We propose a theory of asset pricing based on heterogeneous agents who continually adapt their expectations to the market that these expectations aggregatively create. And we explore the implications of this theory computationally using our Santa Fe artificial stock market. Asset markets, we argue, have a recursive nature in that agents ’ expectations are formed on the basis of their anticipations of other agents ’ expectations, which precludes expectations being formed by deductive means. Instead traders continually hypothesize—continually explore—expectational models, buy or sell on the basis of those that perform best, and confirm or discard these according to their performance. Thus individual beliefs or expectations become endogenous to the market, and constantly compete within an ecology of others ’ beliefs or expectations. The ecology of beliefs co-evolves over time. Computer experiments with this endogenous-expectations market explain one of the more striking puzzles in finance: that market traders often believe in such concepts as technical trading, “market psychology, ” and bandwagon effects, while academic theorists believe in market efficiency and a lack of speculative opportunities. Both views, we show, are correct, but within different regimes. Within a regime where investors explore alternative expectational models at a low rate, the market settles into the rational-

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

Consider the postage stamp. As title to a future good (or, in this case, service) with monetary value, this humble object is essentially the same as a security. Its value, 37 cents, can be identiÞed with the present value of the service (delivery of a letter) to which its owner is entitled.

useful comments while writing my Ph.D. dissertation at Harvard University, on which this article heavily draws The Peso Problem Hypothesis has often been advocated in the …nancial literature to explain the historically puzzlingly high risk premium of stock returns. Using a dynamic model of learning, this paper shows that the implications of the Peso Problem Hypothesis are much more far reaching than the ones commonly advocated, implying most of the stylized facts about stock returns. These include high risk premia, time-varying volatility, asymmetric volatility reaction to good and bad news, excess sensitivity of price reaction to dividend changes and Stock market returns have a number of features that have been puzzling …nancial economists for long. Among others, these include a high realized risk premium, excess volatility, changing volatility, asymmetric reaction of volatility to good and bad news. 1 The …nancial literature

We investigate the role played by the anchoring-and-adjustment heuristic in the speculative bubbles dynamics. In order to link anchoring bias and price deviations from fundamental value, we develop a stock market equilibrium model with heterogeneous investors: fundamental investor anchoring to past stock market prices and noise traders. The equilibrium model we derive suggests that price is a function of fundamental value, past price, noise and anchoring level. Based on our model, we run a set of Monte Carlo experiments with various anchoring levels: no anchoring, low anchoring and high anchoring. We bring the evidence that large speculative bubbles can only occur when fundamental traders highly anchor to stock market prices. Noise cannot in itself cause such phenomenon. Our findings also suggest that a high anchoring level is consistent with slowly mean reverting bubbles lasting many years.

Dinah began her environmental management career in Budapest, Hungary in 1992 when she launched the first office paper recycling system in Budapest office buildings. Working with the Ministry for Environment, Budapest City Government, business and multiple environmental NGO’s, she promoted interest and activity in environmental protection during the early years of Hungary’s transition to a market economy. From 1993 to 1995 she worked as Environmental Manager for Tetra Pak in Hungary. In 1995 she returned to the US to do her masters in law and diplomacy at the Fletcher School, Tufts University, focusing on issues of trade and environment and corporate environmental management. Since then she has been exploring the financial impacts of corporate environmental policy, and helped develop environment, health and safety accounting systems at Baxter International. She is working on her doctorate at Harvard School of Public Health, where she is developing a method for analyzing human toxicity associated with industrial emissions to aid financial analysts and social fund managers in determining the social impacts of investment opportunities. 1 A series of empirical analyses in the United States from 1993-2001 reviewed here provide insight into whether there is a systematic relationship between environmental and financial performance and whether it is strong enough to inform both regulatory and firm environmental strategy. The findings seem to imply that capital markets react long-term to environmental performance. However, a closer look at the research indicates that U.S. capital markets pay attention to environmental news, but that it is a short-term reaction and will not necessarily affect long-term returns. Econometric concerns and model misspecification consistently undermine the quality of findings.

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