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and Jason Zweig for useful conversations and to Lipper Analytical Services for data on Texas municipal bond funds. Familiarity Breeds Investment by

Recent literature in empirical finance is surveyed in its relation to underlying behavioral principles, principles which come primarily from psychology, sociology and anthropology. The behavioral principles discussed are: prospect theory, regret and cognitive dissonance, anchoring, mental compartments, overconfidence, over- and underreaction, representativeness heuristic, the disjunction effect, gambling behavior and speculation, perceived irrelevance of history, magical thinking, quasi-magical thinking, attention anomalies, the availability heuristic, culture and social contagion, and global culture. Theories of human behavior from psychology, sociology, and anthropology have helped motivate much recent empirical research on the behavior of financial markets. In this paper I will survey both some of the most significant theories (for empirical finance) in these other social sciences and the empirical finance literature itself. Particular attention will be paid to the implications of these theories for the efficient markets hypothesis in finance. This is the hypothesis that financial prices efficiently incorporate all public

This article was UCLA/ Anderson Finance Working Paper no. 10-98. I am grateful for comments fi'om Shlomo Benartzi, Michael J. Brennan, John Cochrane, Amit Goyal, Mark Grinblatt, Jay Ritter, Robert Shiller, Jeremy Siegel, Rene Stulz, Richard Thaler, David Wessels, and Fred Weston. I thank Patrick Ctmningham for providing information about Greenwich Associates' survey of fund managers

We analyze the loan pricing implications of the reform of bank capital regulation known as Basel II. We consider a perfectly competitive market for business loans where, as in the model underlying the internal ratings based (IRB) approach of Basel II, a single risk factor explains the correlation in defaults across firms. Our loan pricing equation implies that low risk firms will achieve reductions in their loan rates by borrowing from banks adopting the IRB approach, while high risk firms will avoid increases in their loan rates by borrowing from banks that adopt the less risk-sensitive standardized approach of Basel II. We also show that only a very high social cost of bank failure might justify the proposed IRB capital charges, partly because the net interest income from performing loans is not counted as a buffer against credit losses. A net interest income correction for IRB capital requirements is proposed.

ABSTRACT—Can dysfunction in neural systems subserving emotion lead, under certain circumstances, to more advantageous decisions? To answer this question, we investigated how normal participants, patients with stable focal lesions in brain regions related to emotion (target patients), and patients with stable focal lesions in brain regions unrelated to emotion (control patients) made 20 rounds of investment decisions. Target patients made more advantageous decisions and ultimately earned more money from their investments than the normal participants and control patients. When normal participants and control patients either won or lost money on an investment round, they adopted a conservative strategy and became more reluctant to invest on the subsequent round; these results suggest that they were more affected than target patients by the outcomes of decisions made in the previous rounds. In contrast to the historically dominant view of emotions as a negative influence in human behavior (Peters & Slovic, 2000), recent research in neuroscience and psychology has highlighted the positive roles played by emotions in decision making (Bechara,

When investors make financial plans, their strategies depend on the returns they expect from investments in the stock market. The expected returns from stocks affect how much investors save, how long they plan to work, and how they allocate their portfolios among alternative investments. Their strategies are most likely to be successful, of course, when they have realistic expectations about stock returns. Over the past several years, stock returns have exceeded their long-run historical averages. For example, the 15 percent average annual return on stocks over the last decade is substantially higher than the 10 percent average return

The rise of index funds has been one of the most remarkable phenomena in the fund industry over the last 25 years. The traditional rationale for the success of index funds is based on market efficiency, net of transactions costs. In addition, we focus on the role played by agency conflicts between fund managers and investors, which are hard to resolve given the low power of statistical tests of performance. Most of the empirical evidence about the superiority of index funds is from the US. We discuss issues in the application of index funds in developing countries, and the policy issues in the financial sector that impact on the enabling market infrastructure for index funds. Finally, we apply these ideas to thinking about the relevance of index funds in pension investment. Contents The idea of index funds The rationale for index funds Does active management yield excess returns? Agency problems

ABSTRACT—Can dysfunction in neural systems subserving emotion lead, under certain circumstances, to more advantageous decisions? To answer this question, we investigated how normal participants, patients with stable focal lesions in brain regions related to emotion (target patients), and patients with stable focal lesions in brain regions unrelated to emotion (control patients) made 20 rounds of investment decisions. Target patients made more advantageous decisions and ultimately earned more money from their investments than the normal participants and control patients. When normal participants and control patients either won or lost money on an investment round, they adopted a conservative strategy and became more reluctant to invest on the subsequent round; these results suggest that they were more affected than target patients by the outcomes of decisions made in the previous rounds. In contrast to the historically dominant view of emotions as a negative influence in human behavior (Peters & Slovic, 2000), recent research in neuroscience and psychology has highlighted the positive roles played by emotions in decision making (Bechara,

This article was UCLA/ Anderson Finance Working Paper no. 10-98. I am grateful for comments from Shlomo Benartzi, Michael J. Brennan, John Cochrane, Amit Goyal, Mark Grinblatt, Jay Ritter, Robert Shiller, Jeremy Siegel, Rene Stulz, Richard Thaler, David Wessels, and Fred Weston. I thank Patrick Cunningham for providing information about Greenwich Associates' survey of fund managers