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

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

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I provide a synthesis of the Behavioural finance literature over the past two decades. I review the literature in three parts, namely, (i) empirical and theoretical analyses of patterns in the cross-section of average stock returns, (ii) studies on trading activity, and (iii) research in corporate finance. Behavioural finance is an exciting new field because it presents a number of normative implications for both individual investors and CEOs. The papers reviewed here allow us to learn more about these specific implications.

I provide a synthesis of the behavioral finance literature over the past two decades. I review the literature in three parts, namely, (i) empirical and theoretical analyses of patterns in the cross-section of average stock returns, (ii) studies on trading activity, and (iii) research in corporate finance. Behavioral finance is an exciting new field because it presents a number of normative implications for both individual investors and CEOs. The papers reviewed here allow us to learn more about these specific implications.

One approach to the analysis of stochastic fluctuations in market prices is to model characteristics of investor behaviour and the complex interactions between market participants, with the aim of extracting consequences in the aggregate. This agent-based viewpoint in finance goes back at least to the work of Garman (1976) and shares the philosophy of statistical mechanics in the physical sciences. We discuss recent developments in market microstructure models. They are capable, often through numerical simulations, to explain many stylized facts like the emergence of herding behavior, volatility clustering and fat tailed returns distributions. They are typically queueing-type models, that is, models of order flows, in contrast to classical economic equilibrium theories of utility-maximizing, rational, “representative ” investors. Mathematically, they are analyzed using tools of functional central limit theorems, strong approximations and weak convergence. Our main examples focus on investor inertia, a trait that is well-documented, among other behavioral qualities, and modelled using semi-Markov switching processes. In particular, we show how inertia may lead to the phenomenon of long-range dependence in stock

Executive Compensation and Investor Clientele Executive compensation has increased dramatically in recent times, but so has trading volume and individual investor access to financial markets. We provide a model where due toalackofsophisticationortonaïveté, possibly arising from high opportunity costs of learning about accounting conventions and financial markets, small investors are unable to decipher true executive compensation accurately. Expected compensation is therefore higher when small investors form a more significant clientele in the market for a firm’s stock. Our model further suggests that increased information asymmetry between large and small traders may deter the entry of small investors and keep executive compensation in check. Technologies that lower the cost of trading facilitate entry of small investors and raise expected compensation. In general, such compensation can be reduced through requirements that increase disclosure transparency. Empirical tests provide support to the key implication of the model that indirect executive compensation is higher in stocks Issues surrounding executive compensation have taken on increased prominence in recent

When agents first become active investors in financial markets, they are relatively inexperienced. We focus on the incentives of economic agents to educate these individuals. A feature of the financial market arena is that the agents best positioned to educate the inexperienced themselves stand to earn trading profits at the expense of inexperienced agents. Owing to this phenomenon, we show that the equilibrium amount of financial education may not fully correct the biases of the inexperienced agents. Thus, biased agents may not be fully educated by those with the best financial knowledge. This result complements hindrances to learning due to the self-attribution bias. With monopolistic delivery of financial education, the equilibrium proportion of educated agents tends to decrease with the profit potential of the information possessed by sophisticated agents, suggesting a policy need to reduce the informational advantage of agents with privileged access to information. On the other hand, in a competitive setting, increasing the variance of information tends to increase the rents from trading The notion that irrational investors may be prevalent in financial markets has taken on increased impetus in recent years. For example, while early empirical studies by Black,

Individual investors often invest actively and lose thereby. Social interaction seems to exacerbate the bias toward active trading. In the model here, conversational biases in the social transmission of performance information favor active over passive investment strategies. Senders ’ propensity to communicate their returns is increasing in returns. Receivers’ propensity to attend to and be converted by senders is increasing and convex in sender return. Active strategies (high variance, skewness, and personal involvement) dominate the population unless the mean return penalty to active investing is too large. Thus, the model can explain overvaluation of assets with these characteristics even if investors have no inherent preference over them.

We analyze individuals ’ mutual fund holdings and trades to examine hypotheses regarding the effects of reputation on individuals ’ mutual fund investment decisions. We present three key findings that suggest the importance of fund family reputation on mutual fund choice. First, even though our sample investors are purchasing funds through a discount brokerage firm, we find that individuals cluster their investments within particular families. Second, we show that sample investors are significantly more likely to purchase funds from families with which they have previous experience. Finally, we show that individuals ’ beliefs about funds belonging to older and larger families change slowly, as evidenced by decreased flow-performance sensitivity for these funds. Reputation and Mutual Fund Choice Reputational capital is an important asset for many firms, particularly for firms that offer experience goods because reputation provides a signal of product quality. A firm’s reputation can be gained through many avenues such as marketing, performance, service, media coverage, and word-of-mouth. Reputation can influence the relation between lenders and borrowers (Diamond, 1989, 1991); can affect the actions of traders