This paper surveys the field of asset pricing. The emphasis is on the interplay between theory and empirical work and on the trade-off 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 cross-sectional 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

The use of price--earnings ratios and dividend-price ratios as forecasting variables for the stock market is examined using aggregate annual US data 1871 to 2000 and aggregate quarterly data for twelve countries since 1970. Various simple efficient-markets models of financial markets imply that these ratios should be useful in forecasting future dividend growth, future earnings growth, or future productivity growth. We conclude that, overall, the ratios do poorly in forecasting any of these.

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

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.

Dallas, and the First Annual Texas Finance Festival for discussions and comments helpful to the evolution of the paper. Pattarake Sarajoti provided valuable assistance. Mann acknowledges the support of the Charles Tandy American Enterprise Center. A good portion of this work was completed while Locke was on the staff of the U.S. Commodity Futures Trading Commission. However, the views expressed are the authors ’ only and do not purport to represent the views of the Commodity Futures Trading Commission or its staff. Do Professional Traders Exhibit Loss Realization Aversion? Recent evidence (e.g. Odean, 1998a) describes investor behavior that is at odds with traditional economic theory. These alternative behaviors, such as those consistent with the disposition effect or overconfidence, form the basis for recent "behavioral " explanations for asset returns (e.g. Daniel, Hirshleifer and Subrahmanyam 1998a and 1998b, Odean 1998b, and Shumway, 1998). Notably, the evidence of alternative investor behavior is based largely on retail customer accounts- those of amateur traders. In this paper we examine trades by populations of professional futures traders for evidence of activity best described by the “behavioral finance ” literature. The data provide

Markets have internal dynamics leading to excess volatility and other phenomena that are difficult to explain using rational expectations models. This paper studies these using a nonequilibrium price formation rule, developed in the context of trading with market orders. Because this is so much simpler than a standard inter-temporal equilibrium model, it is possible to study multi-period markets analytically. There price dynamics have second order oscillatory terms. Value investing does not necessarily cause prices to track values. Trend following causes short term trends in prices, but also causes longer-term oscillations. When value investing and trend following are combined, even though there is little linear structure, there can be boom-bust cycles, excess and temporally correlated volatility, and fat tails in price fluctuations. The long term evolution of markets can be studied in terms of flows of money. Profits can be decomposed in terms of aggregate pairwise correlations. Under reinvestment of profits this leads to a capital allocation model that is equivalent to a standard model in population

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.

Yes! We study the time-varying risk patterns of value and growth stocks across business cycles. We find that the conditional market betas of value stocks covary positively with the expected market risk premium, and that value stocks are riskier than growth stocks in bad times when the expected market risk premium is high. The opposite is true for growth stocks. Methodologically, we measure time-varying risk by sorting conditional betas on the theoretically justified expected market risk premium, instead of the ex post realized market excess return. Our findings lend support to the predictions of recent rational asset pricing theory.

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ABSTRACT. The reaction time of financial markets presently constitutes one of the major challenges facing the State. Using the results of a qualitative research study, the current work aims to formulate and to discuss a hypothesis concerning the short-termism of financial markets by presenting an analysis of the temporal horizons and cognitive maps of actors who «make or break » prices on emerging markets. Behind the power of the market hides a multitude of actors, analysts, strategists, economists, and portfolio managers who constitute a veritable epistemic community with its own dynamic of opportunity and constraint. Our aim in this paper is to unravel the various strands in the tapestry that weaves the interactions of those who «make the market » together. It is not embroidered by the invisible hand of god, or the devil, but, more simply, by the unceasing anticipations and interactions of a myriad of analysts and investors who draw their breath from Wall Street. «But, because crises can be self-fulfilling, sound economic policy is not sufficient to gain market confidence; one must cater to he perceptions, the prejudices, and the whims of the market. Or, rather, one must cater to what one hopes will be the perception of