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

The paper discusses the current state of the behavioral finance literature. I argue that more direct evidence on investors ’ actions and expectations would make existing theories more convincing to outsiders and would help sort among behavioral theories for a given asset pricing phenomenon. Furthermore, evidence on the dependence of a given bias on investor wealth/sophistication would be useful for determining if the bias could be due to (fixed) information or transactions costs or is likely to require a behavioral explanation, and for determining which biases are likely to be most important for asset prices. I analyze a novel data set on investor expectations and actions obtained from UBS PaineWebber/Gallup. The data suggest that, even for high wealth investors, expected returns were high at the peak of the market, many investors thought the market was overvalued but would not correct quickly, and investors ’ beliefs depend strongly on their own investment experience. I then review evidence on the dependence of a series of “irrational ” investor behaviors on investor wealth and conclude that many such behaviors diminish substantially with wealth. As an example of the cost needed to explain a particular type of “irrational”

We review the international finance literature to assess the extent to which international factors affect financial asset demands and prices. International asset pricing models with mean-variance investors predict that an asset’s risk premium depends on its covariance with the world market portfolio and, possibly, with exchange rate changes. The existing empirical evidence shows that a country’s risk premium depends on its covariance with the world market portfolio and that there is some evidence that exchange rate risk affects expected returns. However, the theoretical asset pricing literature relying on mean-variance optimizing investors fails in explaining the portfolio holdings of investors, equity flows, and the time-varying properties of correlations across countries. The home bias has the effect of increasing local influences on asset prices, while equity flows and cross-country correlations increase

The paper has also benefited from the comments of the participants at the Chicago Quantitative Alliance spring meeting, Federal Reserve Bank of New York finance workshop, Harvard University Department of Economics finance seminar, MIT Sloan School of Management finance brown-bag lunch and finance seminar, NBER Behavioral Finance working group meeting, and Stanford Business School finance seminar. Errors and omissions remain our responsibility. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

This paper presents a model of portfolio choice and stock trading volume with lossaverse investors. The demand function for risky assets is discontinuous and non-monotonic: as wealth rises beyond a threshold investors follow a generalized portfolio insurance strategy. This behavior is consistent with the evidence in favor of the disposition effect. In addition, loss-averse investors will not hold stocks unless the equity premium is quite high. The elasticity of the aggregate demand curve changes substantially, depending on the distribution of wealth across investors. In an equilibrium setting the model generates positive correlation between trading volume and stock return volatility, but suggests that this relationship should be non-linear.

We study return volatility and trading volume at times of earnings announcements to see if the increased disclosure faced by non-U.S. firms when listing shares in the U.S. has economically significant consequences. We find a surprising change in market behavior around earnings releases: return and volume reactions to earnings announcements typically increase significantly once a stock cross-lists in the U.S. Furthermore, the change in information environment is greatest for firms from developed countries and firms that do not list on an organized stock exchange. The increased market reaction to earnings shocks after cross listing is particularly prominent for firms from developed countries with relatively weak disclosure requirements.

Using transaction data from the Jakarta Stock Exchange, I find three pieces of evidence which indicate that domestic investors have an information advantage over foreign investors. First, foreign investors systematically buy at higher and sell at lower intra-day prices than domestic investors. Second, foreign investors tend to sell prior to large positive returns. Finally, the permanent impact of foreign purchases is smaller than that of domestic purchases. Over time, prices at which foreign investors trade have worsened, while foreign selling prior to positive returns has disappeared.

Tax-Loss Trading and Wash Sales An analysis of trades in the Finnish stock market around the turn of the year 1994-95, 199596, and 1996-97 shows that Finnish investors tend to realize losses more than gains towards the end of December. They also buy back the same stocks they recently sold, with a repurchase rate that depends on the size of the capital loss and how close the sale is to the end of December. The resulting net buying pressure from these "wash sale" repurchases is greater for stocks with small market capitalizations and has a calendar pattern that is similar to that of stock returns. JEL classification: G10 1. Introduction Most researchers in finance suspect that tax-loss selling of stocks occurs at the end of the year, but there is little direct evidence that tax considerations actually motivate end-of-year trading in these securities. Moreover, while research hints that the January effect may be tied to December tax-loss selling, no one has documented whether purchase...

2.37. Small trades and the cross-section of stock returns This paper uses volume arising from small trades to analyze the effect of retail investor trading behavior on the cross-section of stock returns. The central finding is that stocks with intense sell-initiated small-trade volume, measured over the past several months, outperform stocks with intense buy-initiated small-trade volume. This return difference accrues from the first month after the portfolio formation up to three years later. The results suggest that stocks favored by retail investors become overvalued and subsequently experience prolonged underperformance relative to stocks out of favor with retail investors. A literature has emerged which finds systematic trading behavior among various investor groups. For instance, individual investors are found to quickly realize gains, but refrain from realizing losses; mutual funds and other institutional investors tend to follow momentum strategies, while individuals tend to be short-term contrarians, but longer-term momentum traders; a strong seasonal component exists to individuals ’ trading behavior; trading frequency by individuals depends on gender; small and large investors respond differently to events such as earnings releases, seasoned equity offerings, and analysts ’ recommendations.

We document the equity trading practices of approximately 1,200 institutions from the third quarter of 1987 through the third quarter of 1995. We decompose trading by institutions into the initiation of new positions (entry), the termination of previous positions (exit), and adjustments to ongoing holdings. Institutions act as momentum traders when they enter stocks but as contrarian traders when they exit or make adjustments to ongoing holdings. We find significant differences in trading practices among different types of institutions. In a celebrated article published almost a half century ago, Friedman (1953) argues that rational speculation must stabilize asset prices. More recently, DeLong, Shleifer, Summers and Waldmann (DSSW, 1990) show that momentum traders (also referred to as trend chasers or positive feedback traders) can in fact destabilize stock prices and thereby threaten the efficiency of financial markets. DSSW’s proof has inspired numerous empirical investigations that focus almost exclusively on the behavior of institutional investors. There are at least two reasons for this focus. First, a large fraction of corporate equity is held by institutional investors; institutional ownership of shares in U.S. firms increased from approximately seven percent in