Award at the 2005 European Finance Association Meeting, to the retail broker and discount

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 examine changes in the stock trading behavior and investment performance of 1,607 investors who switch from phone based to online trading during the period 1992 to 1995. We document that young men who are active traders with high incomes and a preference for investing in small growth stocks with high market risk are more likely to switch to online trading. We also find that those who switch to online trading experience unusually strong performance prior to going online, beating the market by more than two percent annually. After going online, they trade more actively, more speculatively, and less profitably than before-- lagging the market by more than three percent annually. A rational response to reductions in market frictions (lower trading costs, improved execution speed, and greater ease of access) does not explain these findings. The increase in trading and reduction in performance of online investors can be explained by overconfidence augmented by self-attribution bias, the illusion of knowledge, and the illusion of control.

Abstract. This paper provides an in depth analysis of an investor’s reluctance to realize losses and his propensity to realize gains – a behavior known as the disposition effect. Together, sophistication (static differences across investors) and trading experience (evolving behavior of a single investor) eliminate the reluctance to realize losses. However, an asymmetry exists as sophistication and trading experience reduce the propensity to realize gains by 37 % (but fail to eliminate this part of the behavior.) Our research design allows us to follow an individual’s behavior from the start of his investing life/career. This ability makes it possible to track the evolution of the disposition effect as it is reduced and/or disappears. Our results are robust to alternative explanations including feedback trading, calendar effects, and frequency of observation. 1.

Economists have long been puzzled by the tendency of investors to sell winning investments too soon and hold losing investments too long. Several behavioral explanations for this phenomenon, known as the disposition effect, have been advanced. This paper demonstrates that disposition effects are not intrinsically at odds with rational behavior. Specifically, we show (i) that disposition effects arise quite naturally in a world with changing information asymmetry, (ii) that existing empirical tests rejecting an information-based explanation are inconclusive, and (iii) that disposition effects are consistent with price momentum. We further derive new empirical implications relating disposition behavior to trading volume, return variability, and price dynamics.

Prior experimental and empirical research documents that many investors have a lower propensity to sell those stocks on which they have a capital loss. This behavioral phenomenon, known as \the disposition e®ect, " has implications for equilibrium prices. We investigate the temporal pattern of stock prices in an equilibrium that aggregates the demand functions of both rational and disposition investors. The disposition e®ect creates a spread between a stock's fundamental value { the stock price that would exist in the absence of a disposition e®ect { and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. Spread convergence, arising from the random evolution of fundamental values, generates predictable equilibrium prices. This convergence implies that stocks with large past price run-ups and stocks on which most investors experienced capital gains have higher expected returns than those that have experienced large declines and capital losses. The pro¯tability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Crosssectional empirical tests of the model ¯nd that stocks with large aggregate unrealized

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∗We are grateful to the Center for China in the World Economy (CCWE) of the School

We analyze trading records for 66,465 households at a large discount broker and 665,533 investors at a large retail broker to document that the trading of individuals is highly correlated and persistent. This systematic trading of individual investors is not primarily driven by passive reactions to institutional herding, by systematic changes in risk-aversion, or by taxes. Psychological biases likely contribute to the correlated trading of individuals. These biases lead investors to systematically buy stocks with strong recent performance, to refrain from selling stocks held for a loss, and to be net buyers of stocks with unusually high trading volume.