Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.

The basic paradigm of asset pricing is in vibrant flux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.

Various theories have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein (1999) and establish three key results. First, once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work better among stocks with low analyst coverage. Finally, the effect of analyst coverage is greater for stocks that are past losers than for past winners. These findings are consistent with the hypothesis that firm-specific information, especially negative information, diffuses only gradually across the investing public. SEVERAL RECENT PAPERS HAVE DOCUMENTED that, at medium-term horizons ranging from three to 12 months, stock returns exhibit momentum-that is, past winners continue to perform well, and past losers continue to perform poorly. For example, Jegadeesh and Titman (1993), using a U.S. sample of NYSE/ AMEX stocks over the period from 1965 to 1989, find that a strategy that buys past six-month winners (stocks in the top performance decile) and shorts past six-month losers (stocks in the bottom performance decile) earns approximately one percent per month over the subsequent six months. Not only is this an economically interesting magnitude, but the result also appears to be robust: Rouwenhorst (1998) obtains very similar numbers in a

Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.”

I review empirical research on the relation between capital markets and financial statements.The principal sources of demand for capital markets research in accounting are fundamental analysis and valuation, tests of market efficiency, and the role of accounting numbers in contracts and the political process.The capital markets research topics of current interest to researchers include tests of market efficiency with respect to accounting information, fundamental analysis, and value relevance of financial reporting.Evidence from research on these topics is likely to be helpful in capital market investment decisions, accounting standard setting, and corporate financial

Abstract Using data from Finland, this study analyzes the extent to which past returns determine the propensity to buy and sell. It also analyzes whether these di!erences in past-return-based behavior and di!erences in investor sophistication drive the performance of various investor types. We "nd that foreign investors tend to be momentum investors, buying past winning stocks and selling past losers. Domestic investors, particularly households, tend to be contrarians. The distinctions in behavior are consistent across a variety of past-return intervals. The portfolios of foreign investors seem to outperform the portfolios of households, even after controlling for behavior di!erences. 2000 Elsevier Science S.A. All rights reserved. JEL classixcation: G10

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Market microstructure studies the process by which investors’ latent demands are ultimately translated into prices and volumes. This paper reviews the theoretical, empirical and experimental literature on market microstructure relating to: (1) price formation, including the dynamic process by which prices come to impound information, (2) market structure and design, including the relation between price formation and trading protocols, (3) Transparency, the ability of market participants to observe information about the trading process, and (4) Applications to other areas of finance including asset pricing,

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