Prospect theory, developed by Kahneman and Tversky (1979), asserts that people
focus more on changes in their wealth compared to the level of their wealth.
Loughran and Ritter (2002) apply prospect theory of Kahneman and Tversky (1979) to IPO
market to argue that issuers are more tolerant of excessive underpricing and that they accept
underpricing more than necessary if they simultaneously learn about an aftermarket valuation
that is higher than expected. They are more concerned with an increase in their future wealth
rather than instantaneous and immediate profits. Loughran and Ritter argue that the issuing
firm’s executives bargain less hard for a higher offer price, if they are seeing a personal wealth
increase relative to what they had expected based on the file price range that they have fixed,
and this is when the price is revised upwards during the bookbuilding process.
Loughran and Ritter explain more this theory by the fact that insiders of IPO companies
consider not only the shares they sell in the IPO, but also those they retain which benefit from
the large initial price run-up.
Combining prospect theory reference point with Thaler’s (1980, 1985) notion of mental
accounting, Loughran and Ritter argue that issuers fail to “get upset” about leaving millions
of dollars “on the table” in the form of large first-day returns because they tend to sum the
wealth loss due to underpricing with the (often larger) wealth gain on retained shares as prices
jump in the after-market. Underpricing and the positive initial return is perceived as a wealth
loss under the assumption that shares could have been sold at the higher first-day trading
price. If the perceived gain exceeds the underpricing loss, the decision-marker (issuer) is
satisfied with the IPO underwriter’s performance at the IPO. He is satisfied even if he leaves
large amount on the table and he accepts the underpricing even if it is higher than necessary
since he can compensate this loss by a larger wealth gain. He can benefit from the first day
price run-up since he will sell the shares retained at a higher price which will generate a large
profit compensating the loss undergone by underpricing.
Ljungqvist and Wilhelm (2004) use the structure suggested by Loughran and Ritter’s (2002)
behavioral perspective to test whether CEOs deemed “satisfied” with the underwriter’s
performance according to Loughran and Ritter’s story are more likely to hire their IPO
underwriters to lead-manage later Seasoned Equity Offerings. Controlling for other known
factors, IPO firms are less likely to switch underwriters for their SEO when they were deemed
“satisfied” with the IPO underwriter’s performance. This result confirms what has been
advanced by Loughran and Ritter (2002) about issuers who are not upset about leaving money
on the table and about the tolerance of underpricing believing in a future wealth increase.
Underwriters also appear to benefit from behavioral biases in the sense that they extract
higher fees for subsequent transactions involving “satisfied” decision-makers.
So, for the literature review of behavioral explanations, I begin by presenting the
findings of the first researchers who tried to introduce the behavioral approach and the
investor sentiment, the informational cascade introduced by Welch (1992) and the application
of the prospect theory developed by Kahneman and Tversky (1979) to IPO market.
These two theories were the first explanations of the short run IPO anomaly advanced based
on behavioral approach and investor sentiment. The research effort is continuing and much
investigations and studies are advanced later by the researchers who believe in the behavioral
approach and in the importance of sentiment to explain and to clarify the underpricing
anomaly and to resolve this persistent puzzle over decades in the IPO market.
The behavioral approach has sparked much academic attention and the research effort
has provided numerous analytical advances and empirical insights trying to explain the first
day price run up and the underpricing anomaly by the investor sentiment.
The effect of sentiment investors has been advocated particularly strongly for initial
public offerings. The short run IPO puzzle could be due to overenthusiasm and over optimism
among investors who may be less than perfectly rational. And to study the effect of this type
of investors on IPO market and on the short run IPO anomaly, the sentiment should be
measured which is a very hard to not say that is an impossible task.
Many proxies have been advanced and proposed in the literature to measure the investor
sentiment, or at least to approach it since by its subjective and individual characteristics,
sentiment can not be observable, and then many results have been found. We will see all these
proxies that have been used to measure the investor sentiment and the findings that have been
reached.
So, in the paragraphs that follow, the notion of investor sentiment will be studied by
researchers in more detail and will take another direction based on the over optimism and
over enthusiasm of sentiment and irrational investors.