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.

Award at the 2005 European Finance Association Meeting, to the retail broker and discount

We explore behavioral explanations for sub-optimal corporate investment decisions. Focusing on the sensitivity of investment to cash flow, we argue that personal characteristics of chief executive officers, in particular overconfidence, can account for this widespread and persistent investment distortion. Overconfident CEOs overestimate the quality of their investment projects and view external finance as unduly costly. As a result, they invest more when they have internal funds at their disposal. We test the overconfidence hypothesis, using data on personal portfolio and corporate investment decisions of CEOs in Forbes 500 companies. We classify CEOs as overconfident if they repeatedly fail to exercise options that are highly in the money, or if they habitually acquire stock of their own company. The main result is that investment is significantly more responsive to cash flow if the CEO displays overconfidence. In addition, we identify personal characteristics other than overconfidence (education, employment background, cohort, military service, and status in the company) that strongly affect the correlation between investment and cash flow. We are indebted to Brian Hall and David Yermack for providing us with the data. We are very grateful to Jeremy Stein for his invaluable support and comments. We also would like to thank Philippe Aghion, George

This paper provides one potential explanation for the rise, persistence and eventual fall of internet stock prices. Specifically, we appeal to a model of heterogenous agents with varying degrees of beliefs about asset payoffs who are subject to short sales constraints. In this framework, it is possible that "optimistic" investors overwhelm "pessimistic" ones, leading to prices not reflecting fundamental values about cash flows. Empirical support for this explanation is provided by exploring the behavior of internet stock prices during the period January 1998 to November 2000. In particular, we document four important elements to our story: (i) the high level of internet stock prices given their underlying fundamentals, (ii) responses of stock prices to a shift towards potentially optimistic investors, (iii) empirical results consistent with shorting being at its maximum possible level for internet stocks, and (iv) the eventual fall, or bubble bursting, of intemet stocks being tied to the increase in the number of sellers to the market via expiration of lockup agreements.

This paper investigates the efficiency of household investment decisions in a unique dataset containing the disaggregated wealth and income of the entire population of Sweden. The analysis focuses on two main sources of inefficiency in the financial portfolio: underdiversification of risky assets (“down”) and nonparticipation in risky asset markets (“out”). We find that while a few households are very poorly diversified, the cost of diversification mistakes is quite modest for most of the population. For instance, a majority of participating Swedish households are sufficiently diversified internationally to outperform the Sharpe ratio of their domestic stock market. We document that households with greater financial sophistication tend to invest more efficiently but also more aggressively, so the welfare cost of portfolio inefficiency tends to be greater for these households. The welfare cost of nonparticipation is smaller by almost one half when we take account of the fact that nonparticipants would be unlikely to invest efficientlyiftheyparticipatedinrisky asset markets.

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially

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under a Research Grant to Sodini, the HEC Foundation, the National Science Foundation under Grant This paper investigates the dynamics of individual portfolios in a unique dataset containing the disaggregated wealth and income of all households in Sweden. Between 1999 and 2002, the average share of risky assets in the financial portfolio of participants fell moderately, implying little aggregate rebalancing in response to the decline in risky asset prices during this period. We show that these aggregate patterns conceal strong household-level evidence of active rebalancing, which on average offsets about one half of idiosyncratic passive variations in the risky asset share. Sophisticated households with greater education, wealth, and income, and with better diversified portfolios, tend to rebalance more actively. We find some evidence that households rebalance towards a higher risky share as they become richer. We also study the decisions to enter and exit risky financial markets, and patterns of rebalancing for individual assets. We find that households are more likely to fully sell directly held stocks if those stocks have performed well, and more

This paper investigates the dynamic relation between net individual investor trading and short-horizon returns for a large cross-section of NYSE stocks. The evidence indicates that individuals tend to buy stocks following declines in the previous month and sell following price increases. We document positive excess returns in the month following intense buying by individuals and negative excess returns after individuals sell, which we show is distinct from the previously shown past return or volume effects. The patterns we document are consistent with the notion that risk-averse individuals provide liquidity to meet institutional demand for immediacy. FOR A VARIETY OF REASONS, financial economists tend to view individuals and institutions differently. In particular, while institutions are viewed as informed investors, individuals are believed to have psychological biases and are often thought of as the proverbial noise traders in the sense of Kyle (1985) or Black (1986). One of the questions of interest to researchers in finance is how the behavior of different investor clienteles or their interaction in the market affects

or why speed may matter more than distance