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132
Investor psychology and asset pricing
, 2001
"... 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 understa ..."
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Cited by 393 (23 self)
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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.
Individual Risk Attitudes: New Evidence from a Large, Representative, ExperimentallyValidated Survey
, 2005
"... ..."
Asset pricing at the millennium
 Journal of Finance
"... This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior ..."
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Cited by 185 (0 self)
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This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the tradeoff between risk and return. Modern research seeks to understand the behavior of the stochastic discount factor ~SDF! that prices all assets in the economy. The behavior of the term structure of real interest rates restricts the conditional mean of the SDF, whereas patterns of risk premia restrict its conditional volatility and factor structure. Stylized facts about interest rates, aggregate stock prices, and crosssectional patterns in stock returns have stimulated new research on optimal portfolio choice, intertemporal equilibrium models, and behavioral finance. This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work. Theorists develop models with testable predictions; empirical researchers document “puzzles”—stylized facts that fail to fit established theories—and this stimulates the development of new theories. Such a process is part of the normal development of any science. Asset pricing, like the rest of economics, faces the special challenge that data are generated naturally rather than experimentally, and so researchers cannot control the quantity of data or the random shocks that affect the data. A particularly interesting characteristic of the asset pricing field is that these random shocks are also the subject matter of the theory. As Campbell, Lo, and MacKinlay ~1997, Chap. 1, p. 3! put it: What distinguishes financial economics is the central role that uncertainty plays in both financial theory and its empirical implementation. The starting point for every financial model is the uncertainty facing investors, and the substance of every financial model involves the impact of uncertainty on the behavior of investors and, ultimately, on mar* Department of Economics, Harvard University, Cambridge, Massachusetts
Robust portfolio rules and asset pricing
, 1999
"... Parameter uncertainty or, more broadly, model uncertainty seems highly relevant in many aspects of financial decisionmaking. I explore the effects of such uncertainty on dynamic portfolio and consumption decisions, and on equilibrium asset prices. In particular, I use the framework of Anderson, Ha ..."
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Cited by 93 (0 self)
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Parameter uncertainty or, more broadly, model uncertainty seems highly relevant in many aspects of financial decisionmaking. I explore the effects of such uncertainty on dynamic portfolio and consumption decisions, and on equilibrium asset prices. In particular, I use the framework of Anderson, Hansen and Sargent (1999), which attributes a preference for robustness to the decisionmaker. Worried that the model she uses is misspecified, a robust agent seeks decision rules that insure against some worstcase misspecification, in accordance with maxmin expected utility. I demonstrate that robustness dramatically decreases the portfolio demand for equities. When modifying the framework of Anderson, Hansen and Sargent to impose homotheticity, I find robustness to be observationally equivalent to recursive preferences: robustness increases risk aversion, without affecting the willingness to substitute intertemporally. When investment opportunity sets are timevarying, robustness leads to an additional hedgingtype asset demand, even for logarithmic utility. In an equilibrium exchange economy, robustness increases the equilibrium equity premium. The endogenous worstcase scenario for equity returns supporting the equilibrium is shown to be the equilibrium return generated by a model without robustness. Because of this, matching both the equity premium and the riskfree rate is challenging.
Investor psychology in capital markets: evidence and policy implications
, 2002
"... 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 par ..."
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Cited by 91 (21 self)
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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 selfinterest 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 defaultoptionsetting regulations. Especially
The Market Price of Risk and the Equity Premium: A Legacy of the Great Depression
 Journal of Monetary Economics
, 2008
"... Friedman and Schwartz hypothesized that the Great Depression created exaggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer’s initial confidence in the parameters of a twostate Markov chain that truly governs consumpt ..."
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Cited by 70 (5 self)
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Friedman and Schwartz hypothesized that the Great Depression created exaggerated fears of economic instability. We quantify their idea by using a robustness calculation to shatter a representative consumer’s initial confidence in the parameters of a twostate Markov chain that truly governs consumption growth. The assumption that the consumption data come from the true Markov chain and the consumer’s use of Bayes ’ law cause that initial pessimism to wear off. But so long as it persists, the representative consumer’s pessimism contributes a volatile multiplicative component to the stochastic discount factor that would be measured by a rational expectation econometrician. We study how this component affects asset prices. We find settings of our parameters that make pessimism wear off slowly enough to allow our model to generate substantial values for the market price of risk and the equity premium. Key words: Robustness, learning, asset pricing. 1
The price impact and survival of irrational traders
 Journal of Finance
, 2006
"... Milton Friedman argued that irrational traders will consistently lose money, won’t survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price influence have been assumed to be the same. Often partial equilibrium analysis has been relied upon to exa ..."
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Cited by 61 (2 self)
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Milton Friedman argued that irrational traders will consistently lose money, won’t survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price influence have been assumed to be the same. Often partial equilibrium analysis has been relied upon to examine the survival of irrational traders and to make inferences on their influence on prices. In this paper, we demonstrate that survival and influence on prices are two independent concepts. The price impact of irrational traders does not rely on their longrun survival and they can have a significant impact on asset prices even when their wealth becomes negligible. In addition, in contrast to a partial equilibrium analysis, general equilibrium considerations matter since the ability of irrational traders to impact prices even when their wealth is diminishing can significantly affect their chances for longrun survival. In sum, in a longrun equilibrium, we explicitly show that price impact can occur whether or not the irrational traders survive. In related work, we show that even if the irrational
Anticipated Utility and Rational Expectations as Approximations of Bayesian Decion Making
, 2005
"... We study a Markov decision problem with unknown transition probabilities. We compute the exact Bayesian decision rule and compare it with two approximations. The first is an infinitehistory, rationalexpectations approximation that assumes that the decision maker knows the transition probabilities. ..."
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Cited by 51 (10 self)
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We study a Markov decision problem with unknown transition probabilities. We compute the exact Bayesian decision rule and compare it with two approximations. The first is an infinitehistory, rationalexpectations approximation that assumes that the decision maker knows the transition probabilities. The second is a version of Kreps ’ (1998) anticipatedutility model in which decision makers update using Bayes ’ law but optimize in a way that is myopic with respect to their updating of probabilities. For several consumptionsmoothing examples, the anticipatedutility approximation outperforms the rational expectations approximation. The rational expectations approximation misrepresents the market price of risk in a Bayesian economy. Key words: Rational expectations, Bayes ’ Law, anticipated utility, market price of risk. ∗ For comments and suggestions, we thank Lars Hansen, Narayana Kocherlakota, Frank Schorfheide, three referees, and seminar participants at Stanford and the CFS Summer School
An exploration of the effects of pessimism and doubt on asset returns
 Journal of Economic Dynamics and Control
, 2002
"... Abstract: The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is firstorder stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The ..."
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Cited by 46 (3 self)
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Abstract: The subjective distribution of growth rates of aggregate consumption is characterized by pessimism if it is firstorder stochastically dominated by the objective distribution. Uniform pessimism is a leftward translation of the objective distribution of the logarithm of the growth rate. The subjective distribution is characterized by doubt if it is meanpreserving spread of the objective distribution. Pessimism and doubt both reduce the riskfree rate and thus can help resolve the riskfree rate puzzle. Uniform pessimism and doubt both increase the average equity premium and thus can help resolve the equity premium puzzle.