We study the possibility that, aside from standard sources of utility, investors also derive utility from realizing gains and losses on assets that they own. We propose a tractable model of this “realization utility, ” derive its predictions, and show that it can shed light on a number of puzzling facts. These include the poor trading performance of individual investors, the disposition effect, the greater turnover in rising markets, the effect of historical highs on the propensity to sell, the negative premium to volatility in the cross-section, and the heavy trading of highly valued assets. Underlying some of these applications is one of our model’s more novel predictions: that, even if the form of realization utility is linear or concave, investors can be risk-seeking.

This paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs. Instead of taking a stand on whose belief is correct, our criterion asserts an allocation to be belief-neutral efficient (inefficient) if it is efficient (inefficient) under any convex combination of agents’ beliefs. While this criterion gives an incomplete ranking of social allocations, it can identify positive- and negative-sum speculation driven by conflicting beliefs in a broad range of prominent models.

Abstract: We use seasonality in stock trading activity associated with summer vacation as a source of exogenous variation to study the relationship between trading volume and expected return. Using data from 51 stock markets, we first confirm a widely held belief that stock turnover is significantly lower during the summer because market participants are on vacation. Interestingly, we find that mean stock return is also lower during the summer for countries with significant declines in trading activity. This relationship is not due to time-varying volatility. Moreover, both large and small investors trade less and the price of trading (bid-ask spread) is higher during the summer. These findings suggest that heterogeneous agent models are essential for a complete understanding of asset prices.

In 2005–2008, over a dozen put warrants traded in China went so deep out of the money that they were almost certain to expire worthless. Nonetheless, each warrant was traded more than three times each day at substantially inflated prices. This bubble is unique in that the underlying stock prices make warrant fundamentals publicly observable and that warrants have predetermined finite maturities. This sample allows us to examine a set of bubble theories. In particular, our analysis highlights the joint effects of short-sales constraints and heterogeneous beliefs in driving bubbles and confirms several key findings of the experimental bubble literature. (JEL G12, G13, O16, P34) Asset price bubbles, that is, asset prices that exceed the assets ’ fundamental value, have always been a subject of interest to economists. Clear identification of a price bubble is challenging, however, due to the difficulty in measuring an asset’s fundamental value. There is an open debate about whether each historical episode

We model a competitive market where risk-neutral traders trade one risk-free and one risky asset with limited short-selling of the risky asset. Traders use “incomplete theories ” that give statistically correct beliefs about the market price of the risky asset next period conditional upon information contained in their theories this period; they neither condition upon information outside of their theories nor upon current market prices. The more theories are present in the market, the higher is the equilibrium price of the risky asset, which exceeds the most optimistic trader’s expectation of its present-discounted value. When the dividend paid by the risky asset is sufficiently persistent, low asset prices are more volatile than high asset prices. Investors with more complete theories do not necessarily earn higher returns than those with less complete theories, who can earn more than the risk-free rate, despite perfect competition. We thank Ian Jewitt and seminar participants at Berkeley, Bonn, Central European University,

I discuss some ways in which ideas from psychology may be helpful for thinking about the financial crisis of 2007-2008. I focus on three aspects of the crisis: the surge in house prices in the years leading up to 2006; the large positions in subprime-linked securities that many banks had accumulated by 2007; and the dramatic decline in value of many risky asset classes during the crisis period. I review a number of psychology-based mechanisms, but emphasize two, both of which have already been extensively studied in behavioral finance and behavioral economics: over-extrapolation of past price changes; and belief manipulation. 1 Yale School of Management. This essay is in preparation for Financial Innovation and Crisis (MIT Press, Michael Haliassos, ed.). It is based on an invited talk at a conference in 2009 on the occasion of the awarding of the Deutsche Bank Prize in Financial Economics to Robert Shiller. I am grateful to Malcolm

What explains short-term uctuations of stock prices? This paper exploits a natural experiment from the 18th century in which information ows were regularly interrupted for exogenous reasons. English shares were traded on the Amsterdam exchange and news came in on sailboats that were often delayed because of adverse weather con-ditions. The paper documents that prices responded strongly to boat arrivals, but there was considerable volatility in the absence of news. The evidence suggests that this was largely the result of the revelation of (long-lived) private information and the (transitory) impact of uninformed liquidity trades on intermediariesrisk premia.

We examine the 2007 stock market bubble in China. Using multiple measures of bubble intensity for each stock, we find significantly smaller bubbles in stocks for which there is greater analyst coverage. We further show that the abating effect of analyst coverage on bubble intensity is weaker when there is greater disagreement among analysts. This sug-gests that, in line with resale option theories of bubbles, one channel through which analyst coverage may mitigate bubbles is by coordinating investors ’ beliefs and thus reducing its dispersion. Stock turnover provides further evidence consistent with this particular infor-mation mechanism. I.

This chapter reviews the quickly growing literature that builds on heterogeneous beliefs, a widely observed attribute of individuals, to explain bubbles, crises, and endogenous risk in financial markets. This chapter is prepared for Handbook for Systemic Risk edited by Jean-Pierre Fouque and Joe Langsam. I thank Hersh Shefrin for helpful editorial suggestions. The history of financial markets has been dotted with episodes of bubbles, during which market values of assets vastly exceeded reasonable assessments of their fundamental value. Asset price bubbles can lead to severe economic consequences ranging from wasteful over-investment and frenzied trading during booms to devastating financial crises and depressed real economies during busts. Economists have emphasized many aspects of bubbles and crises. Minsky (1974) advocated the view that excessive expansion of bank credit due to optimism can fuel a speculative euphoria and slowly lead the economy to a crisis. Kindleberger (1978) stressed that irrationally optimistic expectations frequently emerge among investors in the late stages of major economic booms and lead firm managers to over-invest, over-promise, and over-leverage, which sow the seeds for an eventual collapse after they fail to deliver on their promises. Shiller (2000) highlighted a host of psychological biases people use in forming a feedback mechanism,

We provide a model for why high beta assets are more prone to speculative overpricing than low beta ones. When investors disagree about the common factor of cash-flows, high beta assets are more sensitive to this macro-disagreement and experience a greater divergence-of-opinion about their payoffs. Short-sales constraints for some investors such as retail mutual funds result in high beta assets being over-priced. When aggregate disagreement is low, expected return increases with beta due to risk-sharing. But when it is large, expected return initially increases but then decreases with beta. High beta assets have greater shorting from unconstrained arbitrageurs and more share turnover. Using measures of disagreement about stock earnings and economic uncertainty, we verify these predictions. A calibration exercise yields reasonable parameter values.