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Abstract:
High market-wide returns make some investors overconfident because they incorrectly attribute the gains to their stock picking talents. Investors who are subject to biased self-attribution increase their trading in subsequent periods in models by Gervais and Odean (2001) and Odean (1998a). We use a vector autoregressive and impulse-response function methodology to investigate the trading volume implication of the overconfidence hypothesis. We find empirical support for the overconfidence hypothesis as well as the disposition affect of Shefrin and Statman (1985). Specifically, market-wide trading activity in NYSE/AMEX shares is positively correlated to past shocks in market return, with the turnover response lasting months and perhaps years. This increase (decrease) in market-wide trading activity subsequent to bull (bear) markets can be explained by either the overconfidence hypothesis or the disposition effect. Vector autoregressions on individual stocks indicate that volume responds to past shocks in individual security return, which prior researchers have interpreted as evidence of disposition effect trading. However, we show that individual security trading activity is even more responsive to past shocks in the market-wide return, which we interpret as evidence of the overconfidence hypothesis. The empirical lead-lag relationships between returns and trading activity as measured by turnover are both statistically and economically significant and an important empirical characteristic of the domestic equity market. The trading volume patterns we document are in addition to well-known volume-volatility relationships and turn-of-the-year effects, and are robust to a number of specification alternatives.

Abstract:
Levels of diversification in the portfolios of investors present a puzzle. The benefits of diversification, measured by the rules of mean-variance portfolio theory, have increased in recent years, yet levels of diversification did not increase, remaining much below their optimal levels. We find that today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 120 stocks, and argue that the diversification puzzle is solved within Shefrin and Statman's (2000) behavioral portfolio theory. Investors in behavioral portfolio theory construct their portfolios as layered pyramids where bottom layers are designed for downside protection while top layers are designed for upside potential. Risk-aversion gives way to risk-seeking at the uppermost layers as they desire to avoid poverty give way to the desire for riches. Some investors fill the uppermost layers with the few stocks of an undiversified portfolio while others fill them with lottery tickets. Neither lottery buying nor undiversified portfolios are consistent with mean-variance portfolio theory but both are consistent with behavioral portfolio theory. Behavioral portfolios, such as those reflected in the rules of "core and satellite," are sensible ways to allocate portfolio assets between the upside potential and downside protection layers. A well-diversified core forms is the downside protection layer of the portfolio and a less diversified satellite forms the upside potential one. The rules of diversification in behavioral portfolio theory are not as precise as the rules in mean-variance portfolio theory, but they are clear enough. Investors, financial advisors, and companies sponsoring 401(k) plans must be careful to draw the line between upside potential and downside protection such that dreams of riches do not plunge investors into poverty.

Diversification, portfolio choice

Abstract:
Financial advisors who worked to restrain exuberant investors in the late 1990s, worked equally hard to lift desperate investors in the early 2000s. Will lower stock prices sap the confidence of consumers? Will lower consumer confidence extinguish all hope for investors?

We study the consumer confidence measures of the Conference Board and the University of Michigan and the investor sentiment measures of the American Association of Individual Investors and Investor's Intelligence. We find that consumers grow confident when investors grow bullish. Consumer confidence declines when stock prices decline but investors need not fear that declines in consumer confidence would be followed by low stocks returns. Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns.

Behavioral Finance, forecasting, tactical asset allocation, investor sentiment

Abstract:
Correlation is the common indicator for the benefits of diversification, but it is not a good indicator. This is for two reasons. First, the benefits of diversification depend not only on the correlations between returns but also on the standard deviations of returns. Second, correlation does not provide an intuitive measure of the benefits of diversification. Return gaps are better indicators. Return gaps are the difference between the returns of two assets or between two portfolios.

For example, the estimated 12-month return gap between the S&P 500 Index and the Russell 2000 Index and during February 2002 - January 2007 was 8.90%, implying that investors who concentrated their portfolios in one index or the other should have expected to lead or lag investors who diversified between the two in equal proportions by 4.45%. The realized 12-month return gaps ranged from 0.1% to 28.7%. It is hard to deduce these figure intuitively from the relatively high 0.82 correlation between the two. Similarly, it is hard to deduce intuitively from the relatively high 0.86 correlation between the S&P 500 and EAFE Indexes that their estimated 12-month return gap was 6.86% and their realized 12-month return gaps ranged from 1.8% to 23.0%. Moreover, the figures belie any claim that these assets' risk-reduction benefits have largely vanished.

behavioral finance, diversification, correlation, return gaps, dispersion, portfolio theory

Abstract:
The price of Berkshire Hathaway shares increased at a rate more than double the rate of the S&P 500 Index, from $18 on May 10, 1965, when Warren Buffett took control of the company, to $71,000 by the end of 2000. We show that while some investors saw Berkshire Hathaway?s amazing performance in foresight, investors as a whole did not. We use this evidence to discuss the pitfalls of hindsight in the assessment of investment foresight.

Buffett, Cognitive Biases, Behavioral Finance, Market Efficiency, Performance Evaluation

Abstract:
One purpose of this study is to explore the characteristics that define socially responsible companies by comparing the content of the S&P 500 Index of conventional companies to the contents of four indexes of socially responsible companies, the Domini 400 Social Index (DS 400 Index), the Calvert Social Index, the Citizens Index, and the U.S. portion of the Dow Jones Sustainability Index. A second purpose of the study is to compare the returns of the four SRI indexes to those of the conventional S&P 500 Index, and to examine the tracking errors of the SRI indexes relative to the S&P 500 Index.

We find that SRI indexes vary in composition and social responsibility scores but the mean social scores of each is higher than that of the S&P 500 Index. Socially responsible indexes differ in the emphasis they place on social characteristics. For example the DS 400 Index is the strongest among all indexes on the environment while the Calvert Index is strongest on corporate governance.

We find that the returns of the DS 400 Index were higher than those of the S&P 500 Index during the overall May 1990 - April 2004 but not in every sub-period. In general, SRI indexes did better than the S&P 500 Index during the boom of the late 1990s but lagged it during the bust of the early 2000s.

The correlations between the returns of SRI indexes and those of the S&P 500 Index are high, ranging from 0.939 of the DJ Sustainability Index during January 1995 - April 2004 to the 0.985 of the DS 400 Index during September 1999 - April 2004. But tracking errors are substantial. For example, the expected difference between 12-month returns of the DS 400 Index and the S&P 500 Index, based on correlation and standard deviations during May 1990 - April 2004, was 2.84% and the realized mean difference was 2.49%.

socially responsible investing, market efficiency, asset pricing, portfolios, behavioral finance

Abstract:
The behavior of stock traders and lottery buyers teaches us about our common aspirations, thoughts and emotions. That behavior also helps us answer the many questions of finance such as the construction of portfolios and the nature of equity premium.

Gambling, lotteries, Behavioral Finance, Trading, Cognitive Biases, Emotions, Aspirations

Abstract:
The behavior of stock traders and lottery buyers teaches us about our common aspirations, thoughts and emotions. That behavior also helps us answer the many questions of finance such as the construction of portfolios and the nature of equity premium.

Gambling, lotteries, Behavioral Finance, Trading, Cognitive Biases, Emotions, Aspirations

Abstract:
Stocks, like houses, cars, watches and most other products exude affect, good or bad, beautiful or ugly, admired or despised. Affect plays a role in pricing models of houses, cars and watches but, according to standard financial theory, affect plays no role in pricing of financial assets. We outline a behavioral asset pricing model where expected returns are high when objective risk is high and also when subjective risk is high. High subjective risk comes with negative affect. Investors prefer stocks with positive affect and their preference boosts the prices of such stocks and depresses their returns.

asset pricing models, market efficiency, behavioral finance, emotions, cognitive biases

Abstract:
Correlations between the returns of US stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between US and international stocks and doubt the benefits of global diversification. We argue that the benefits of global diversification remain high and that the correlation between US and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of US and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation, and dispersion.

Diversification, global diversification

Abstract:
Correlations between the returns of U.S. stocks and international stocks were higher recently than in the past, reaching 0.86 during the 60 months ending in December 2003. Today's investors note the high correlations between U.S. and international stocks and doubt the benefits of global diversification.

We argue that the benefits of global diversification remain high and that the correlation between U.S. and international stocks is a misleading measure of the benefits of global diversification. This is for two reasons. First, the benefits of global diversification depend not only on the correlation between the returns of U.S. and international stocks but also on the standard deviations of these returns. Second, we tend to have poor intuition about the link between correlation and the benefits of diversification. A 0.86 correlation seems high enough to eliminate the benefits of diversification, but even correlations much higher than 0.86 are associated with substantial benefits. Dispersion of returns is a better measure of the benefits of diversification because it accounts for the effects of both correlation and standard deviation and because it provides an intuitive measure of the benefits of diversification. We present the relationship between correlation, standard deviation and dispersion.

Diversification, behavioral portfolio theory, dispersion, correlation, global portfolios

Abstract:
Today's investors are more rapidly informed than their predecessors a century ago, but they are neither better informed nor better behaved. In this article, a picture of individual investors during 1906-1918 drawn from investor questions to the World's Work magazine is compared with a picture of investors of the 21st century as reflected in today's media. The investors of a century ago, like today's investors, wanted to be secure while they aspired to be rich, wanted to save while they were tempted to spend, wanted to feel the joy of pride and avoid the pain of regret.

Investment Theory: behavioral finance; Investment Industry: other

Abstract:
Today's investors are more rapidly informed than their predecessors a century ago, but they are neither better informed nor better behaved.

We draw a picture of investors during 1906-1918 from investor questions to The World's Work magazine and compare it to the picture of today's investors as reflected in today's media. The investors of a century ago, like today's investors, wanted to be secure while they aspired to be rich, wanted to save while they were tempted to spend, wanted to avoid the pain of regret and escape taxes. As The World's Work wrote, "Human nature is human nature."

Behavioral finance, forecasting, tactical asset allocation, investor sentiment, market efficiency

Abstract:
What do we know about SRI? What distinguishes socially responsible companies from conventional companies? Should investors expect socially responsible investments to yield higher or lower returns than conventional investments? What has been the performance of socially responsible portfolios relative to conventional portfolios? What are the tracking errors of socially responsible portfolios and what can investors do to reduce them? In this article I answer questions about socially responsible investments.

Many financial advisors perceive socially responsible portfolios as undiversified portfolios whose performance is sure to trail that of conventional portfolios. But reality is different from perception. Financial advisors can construct for their investors portfolios that perform as well as conventional portfolios, or even better, whether through mutual funds or separate accounts.

Socially Responsible Investing, Behavioral Finance, Investor Behavior, Asset Pricing Model, Market Efficiency, Portfolios

Abstract:
What do we know about socially responsible investments? What distinguishes socially responsible companies from conventional companies? Should investors expect socially responsible investments to yield higher or lower returns than conventional investments? What has been the performance of socially responsible portfolios relative to conventional portfolios? What are the tracking errors of socially responsible portfolios and what can investors do to reduce them? In this article I answer questions about socially responsible investments.

Many financial advisors perceive socially responsible portfolios as undiversified portfolios whose performance is sure to trail that of conventional portfolios. But reality is different from perception. Financial advisors can construct for their investors portfolios that perform as well as conventional portfolios, or even better, whether through mutual funds or separate accounts.

socially responsible investing, behavioral finance, investor behavior, asset pricing model, market efficiency, portfolios

Abstract:
While correlation is the common indicator of the benefits of diversification, it is not a good indicator. This is for three reasons. First, diversifiable risk depends not only on the correlations between stock returns but also on the standard deviations of stock returns. Second, correlation does not provide an intuitive indicator of the benefits of diversification. Third, expected diversifiable risk, estimated from correlations and standard deviations, is biased when the distribution of the returns of stocks around the mean return of all stocks is not normal. We know diversifiable risk as unsystematic risk, tracking error and dispersion. We analyze diversifiable risk in portfolios of U.S. stocks during 1980-2004.

Diversification, correlations, dispersion, tracking errors, portfolio theory

Abstract:
Do stocks of admired companies yield admirable returns? We study Fortune magazine's annual list of "America's Most Admired Companies" and find that stocks of admired companies had lower returns, on average, than stocks of despised companies during the 23 years from April 1983 through March 2006. We link differences between the returns of stocks of admired and despised companies to differences in affect, the quick feeling that distinguishes good from bad, admired from despised. The affect of admired companies is positive, and investors who were attracted by affect to stocks of admired companies paid for it with lower returns. However, the relative returns of stocks of admired and despised companies varied considerably from year to year and from decade to decade and the relationship between admiration and returns is not always monotonic.

behavioral finance, emotions, cognitive biases, affect, asset pricing models, fortune magazine

Abstract:
Investors were normal in 1945 when the first issue of the Financial Analysts Journal was published, and they remain normal today, 60 years later. But in between was a long period, starting in the late 1950s, when investors were described as rational. The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are market efficiency, mean-variance portfolio theory, and the capital asset pricing model. This article provides descriptions of normal investors as they were portrayed in the FAJ and other finance journals before standard finance was introduced and as they have emerged recently in behavioral finance.

Investment Theory, Behavioral Finance, Efficient Market Theory, CAPM, APT, Other Pricing Theories

Abstract:
The 1960 issue of the Financial Analysts Journal contains a pair of remarkable articles. In the first, Edward F. Renshaw and Paul J. Feldstein proposed the creation of what we know today as index funds. In the second, John B. Armstrong argued against index funds.

John B. Armstrong is a pen-name of John C. Bogle, the founder of Vanguard who introduced the first of many index mutual funds in 1976 and remains their foremost advocate. Bogle reflected on index funds and changed his mind. The 60th anniversary of the Financial Analysts Journal is an opportunity for all of us to reflect on past changes of mind and perhaps contemplate future ones.

The year 1960 was in the midst of an extraordinary time when academics and practitioners of finance were changing their minds, switching from a framework where investors are normal to one where investors are rational. Normal investors are affected by cognitive biases and emotions, while rational investors are not. Rational investors care only about the risk and expected return of their overall portfolios, while normal investors care about more than that.

The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are mean-variance portfolio theory, Capital Asset Pricing Model (CAPM), and market efficiency. I describe normal investors as they were portrayed in the Financial Analysts Journal and other finance journals before standard finance was introduced and as they emerged more recently in behavioral finance.

Behavioral asset pricing theory, behavioral finance, market efficiency, rationality

Abstract:
Correlation is the common measure of the benefits of diversification, but dispersion, measured as the standard deviation of the returns of stocks around the mean of all stocks, is better. This is for two reasons. First, the benefits of diversification depend not only on the correlations between stock returns but also on the standard deviations of stock returns. Dispersion accounts for both. Second, dispersion provides an intuitive measure of the benefits of diversification while correlation does not. We show the relationship between dispersion, correlation and standard deviation and analyze the dispersion of U.S. stocks during 1980-2003.

Behavioral finance, diversification, correlation, dispersion, portfolio theory

Abstract:
Diners want more than the utilitarian benefits of low cost and high nutrition when they choose restaurants, they want the utilitarian benefits of palatability, ambiance and conformity to culture. And they also want the expressive benefits of status, patriotism and social responsibility. Similarly, investors want more than the utilitarian benefits of low risk and high expected returns when they choose investments, they want additional utilitarian benefits and they want expressive benefits as well.

Restaurant journals discuss both the utilitarian benefits of restaurants and their expressive ones, but finance journals are confined to the utilitarian benefits of low risk and high expected returns. I hope that the expressive benefits of investments would be discussed in future issues of finance journals and offer in this article some thoughts about the future of the investment profession and its business.

Behavioral portfolio theory, utilitarian characteristics, behavioral asset pricing theory, behavioral finance

Abstract:
We find that the mean returns and standard deviations of global portfolios with hedged currencies during the 15-year period 1988-2002 were approximately equal to those of portfolios with unhedged currencies. Mean-variance investors who believe that the expected returns and standard deviations of hedged portfolios are equal to those of unhedged portfolios would be indifferent between them but behavioral investors would not be indifferent. Behavioral investors focus on individual securities and the forces of hindsight and regret move them back and forth between hedged portfolio and unhedged ones.

Foreign Currency, Behavioral Finance, Portfolio Theory

Abstract:
Investors who follow different tenets of social responsibility and choose different socially responsible mutual funds can be described as members of different religions. Some social responsibility religions have a single tenet, such as protection of the environment, while other social responsibility religions combine several tenets, such as avoidance of tobacco, alcohol, and weapons.

The framework of the economics of religion can help us answer questions such as:

- Why do some mutual funds attract many investors while others attract few?

- What are the differences between strategies that are effective at attracting individual investors to SRI and those effective at attracting institutional ones?

- How do tenets, such as opposition to tobacco, come to the forefront or recede?

- Are government regulations aimed at fostering SRI likely to accomplish their aim or are they likely to retard SRI? And is the SRI movement likely to grow stronger in the U.S. or in Europe?

Socially responsible investing, behavioral finance, portfolios

Abstract:
Clients want more than advisors who allocate assets in their portfolios. They want advisors who empathize with their goals, whether a secure retirement, a vacation home, or social responsibility. Socially responsible investors want to integrate their personal values into their investment decisions and they look for advisors who do not lecture them about the folly of such integration. Advisors should be flexible enough to adopt clients' goals, even if they do not share them, as long as the pursuit of these goals does not violate the fiduciary duties they owe to their clients.

In Statman (2007), I answered questions about such investments. What distinguishes socially responsible companies from conventional companies? What has been the performance of socially responsible portfolios relative to conventional portfolios? What are the tracking errors of socially responsible portfolios and what can investors do to reduce them? I noted that no company has a perfect score on social responsibility. Some companies are strong on employee relations, some on human rights, and others on concern for the environment. Moreover, some companies that are strong on some social responsibility criteria are weak on others.

Nevertheless, the average social responsibility rating of companies in socially responsible portfolios, such as the Domini Social 400 Index, is higher than the average rating of companies in conventional portfolios, such as the S&P 500 Index. I also noted that financial advisors can construct for their clients socially responsible portfolios that perform as well as conventional portfolios, or even better, whether through mutual funds or separate accounts. Moreover, advisors can control tracking errors of socially responsible portfolios relative to conventional portfolios.

In this article I answer questions about socially responsible investors and their advisors. Do socially responsible investors care about protecting the environment, preventing child labor, or promoting good corporate governance? Do they want consistency between their personal values and their investments or do they hope to improve the world? Do they care only about social responsibility or do they also care about the expected returns and risks of their portfolios? I interviewed investors who have adopted socially responsible investing and investors who have not. I also interviewed advisors who serve socially responsible investors. They include advisors affiliated with Trillium Asset Management, Boston Common Asset Management, First Affirmative Financial Network, and UBS Financial Services.

Socially Responsible Investing, Behavioral Finance, Investor Behavior, Asset Pricing Model, Market Efficiency, Portfolios

Abstract:
Socially responsible investors are similar to conventional investors in some ways but different in others. Like conventional investors, socially responsible investors want high returns and low risk, but socially responsible investors also want their portfolios to conform to their values, whether promotion of worker rights, opposition to war, or protection of the environment.

Financial advisors new to socially responsible investing ask important questions. How can we make sense of socially responsibility when it means different things to different people? Is it right to mix financial goals with social goals. And won't such mixing violate our fiduciary duties?

Socially responsible investing often means different things to different people, but so does risk. It is the role of advisors to explore clients' social, ethical and religious preferences, just as they explore attitudes toward risk. Social questionnaires can facilitate that task as risk questionnaires do.

Mixing non-financial preferences with financial goals is not really new to any financial advisor. For example, advisors routinely accommodate the "home bias" of clients by titling portfolios away from foreign stocks, even when such tilts diminish the benefits of diversification. And socially responsible investing does not violate advisors' fiduciary duties when clients direct such investing in the investment policy statement.

This article presents, in their own words, four financial advisors who advise socially responsible investors. They tell about the life experiences that have drawn them to socially responsible investing and offer lessons about serving socially responsible clients.

socially responsible investing, behavioral finance, investor behavior, asset pricing model, market efficiency, portfolios

Abstract:
Assets are economically liquid when they can be sold quickly with no loss relative to their fair market value. Assets are "mentally liquid" when they offer investors options to obscure losses relative to reference prices and options to avoid their realization. Purchase prices are common references prices but other prices, such as the maximum price reached during the preceding 12 months, might serve as reference price. The price of a 20-year $1,000 Treasury bond purchased for $1,000 a year ago might have declined to $900 because interest rates increased during the year. That bond is almost perfectly economically liquid; investors can sell it for $900 less a small commission. But the mental liquidity of the bond is impaired if investors are unable to avoid observation of paper losses relative to the purchase price or if they feel compelled to postpone the sale of the bond so as to avoid the realization of losses. Still, the bond is more highly mentally liquid than a stock since bondholders have the option to wait till maturity date and avoid the realization of losses while stockholders do not have that option.

Investors like gains and hate losses so they love investments that combine the prospect of gains with protection from losses. The purpose of this article is to describe some of these investments, highlighting the features designed to obscure losses or avoid their realization. These securities include bonds, money market funds, stable value funds and indexed annuities.

liquidity, behavioral finance, bonds, bond ladders, disposition effect

Abstract:
Ethics, fairness, trust and freedom from corruption are all parts of social capital and social capital matters in financial markets because investors consider not only their tradeoff between risk and return based on available information but also their trust in the accuracy of information and the fairness of markets. Deficiencies in ethics and fairness mark all countries but such deficiencies are more pronounced in some countries than in others. Levels of corruptions are higher in some countries such as India, than in others, such as Australia. Rankings by perceptions of the fairness of insider trading generally follow rankings by corruption. A survey presented in this article shows that finance professionals and university students in India, Turkey, Tunisia and Italy perceive insider trading fairer than professionals and students in Australia, the Netherlands, the United States and Israel.

Why are levels of corruption higher in some countries than in others? Why is insider trading considered fairer in some countries than in others? And what can institutions, such as the CFA Institute, do to improve levels of ethics and fairness? These are the questions I try to answer in this article. I discuss four factors that affect social capital, culture, income, education and law enforcement.

ethics, fairness, insider trading, international, behavioral finance

Abstract:
We listen to investors brag about their winning stocks and want to ask "May I have a list of all the stocks in your portfolio?" Polite people resist the urge but prosecutors need not be polite. The portfolio that Martha Stewart revealed to prosecutors and the jury at her trial is a portfolio of normal investors, containing both winners and losers, and the investment behavior she revealed is normal behavior, affected by cognitive biases and emotions. Nothing illustrates these better than the cognitive bias of hindsight and the accompanying emotion of regret.

Martha Stewart surely wishes, in hindsight, that she had not bought the many stocks she sold at a loss in December 2001. Martha Stewart surely wishes, in hindsight, that she had accepted the prosecutors' offer of a plea bargain. Last, and most ironic, Martha Stewart surely wishes, in hindsight, that she had held on to her ImClone stock. The shares she sold for less than $60 in December 2001 could have been sold for more than $85 at the end of June 2004.

Martha Stewart, investor behavior, cognitive biases, emotion, disposition effect

Abstract:
The current global financial and economic crisis highlights the ongoing tug-of-war between those who pull toward free markets and those who pull toward strict regulation of markets - between those who pull toward libertarianism and those who pull toward paternalism. Rising stock markets and economic prosperity empower those who favor free markets and libertarianism; stock market crashes and economic recessions empower those who favor strict regulation and paternalism. This article discusses the current crisis against the backdrop of earlier crises and focuses on margin regulations, which limit leverage; suitability regulations, which require providers of financial products to act in the interests of their clients; blue-sky laws, which prohibit securities deemed unfair or unduly risky; and mandatory-disclosure regulations, which require providers of financial products to disclose pertinent information even if potential buyers do not ask for it.

Advocacy, Regulatory, and Legislative Issues, Advocacy Issues, Regulatory and Legislative Activities, Investment Theory, Behavioral Finance

Abstract:
The global financial and economic crisis of the late 2000s highlights the ongoing tug-of-war between those who pull toward free markets and those who pull toward strict regulation of markets. It also highlights the sometimes parallel and sometimes perpendicular tug-of-war between those who pull toward libertarianism and those who pull toward paternalism. Rising stock markets and economic prosperity add power to those who pull toward free markets and libertarianism, and stock market crashes and economic recessions add power to those who pull toward strict regulation and paternalism. I discuss the crisis of the late 2000s against the backdrop of earlier crises with special focus on margin regulations which limit leverage, suitability regulations which require providers of financial products to act in the interests of their clients, Blue Sky laws which prohibit securities deemed overly risky or unfair, and mandatory disclosure regulations which require providers of financial products to disclose pertinent information even if potential buyers do not ask for it.

regulation, behavioral finance, paternalism, libertarianism, suitability, blue sky, mandatory disclosure, margin, leverage, cognitive errors, emotions

Abstract:
Socially responsible investors attempt to integrate their ethical, societal and religious values with their investments. They find it impossible to separate the utilitarian characteristics of an investment, namely its risk and expected returns, from its expressive characteristic of social responsibility.

Not all values are shared by all investors and not all socially responsible investors are alike, but socially responsible investors find meaning in those words and that meaning is often lost in noisy debates between advocates of socially responsible investing and its detractors.

I present here a few socially responsible investors in their own quiet words. They tell us about their ethical, societal and religious goals and about the experiences that led them to their goals. They also tell us about their investments and their efforts to further their goals beyond their investments. We listen to a nun saying that the most important issue to her order is human rights and human dignity, a video producer telling of the need to balance her desire for socially responsible investing with her financial reality, a student telling of growing up wealthy and awakening to social responsibility by encounters with poor children, and the owner of military related companies arguing that SRI should be about supporting companies that have the best policies and practices rather than companies whose products we like.

socially responsible investing, investor behavior, behavioral finance

Abstract:
When we talk about ethics we often talk about fairness. What are the rules of fairness that govern financial trading?

Social norms, including rules of fairness, are rules of behavior that are enforced by the community and often make their way into law. Community rules of fairness in financial trading are important to all people since financial markets plays an important part in the economy but they are especially important to investors, both insiders and outsiders, to executives, to investment professionals, to students who plan to become executives or investment professionals, and to regulatory agencies, such as the SEC.

I use surveys to elicit rules of fairness from two segments of the community, investment professionals and students. I find that rules of fairness allow one trader to gain advantage over another with information obtained with research, skill or even luck, but they do not allow one trader to gain advantage over another with information, such as inside information, that other traders cannot obtain with research or skill. I find that rules of fairness place special burdens on traders who are well-off and traders who have sure information and that rules of fairness for trading stocks are different from rules of fairness for trading other goods, such as automobiles. I also find differences between the perception of rules of fairness by investment professionals and students.

Behavioral finance, fairness, insider trading, ethics

Abstract:
Typical socially responsible investors tilt their portfolios toward stocks of companies with high scores on social responsibility characteristics such as community, employee relations and the environment. We analyze returns during 1992-2007 of stocks rated on social responsibility by KLD and find that this tilt gave socially responsible investors a return advantage relative to conventional investors. However, typical socially responsible investors also shun stocks of companies associated with tobacco, alcohol, gambling, firearms, military, and nuclear operations. We find that such shunning brought to socially responsible investors a return disadvantage relative to conventional investors. The return advantage of tilts toward stocks of companies with high social responsibility scores is largely offset by the return disadvantage that comes from the exclusion of stocks of 'shunned' companies. The return of the DS 400 Index of socially responsible companies was approximately equal to the return of the S&P 500 Index of conventional companies.

Socially responsible investors can do both well and good by adopting the best-in-class method in the construction of their portfolios. That method calls for tilts toward stocks of companies with high scores on social responsibility characteristics, but refrains from calls to shun the stock of any company, even one that produces tobacco.

socially responsible investing, behavioral finance, market efficiency, sin stocks, environment, employee relations, governance

Abstract:
The purpose of this paper is to explore differences among countries in perceptions of the fairness of trading in financial markets and offer these perceptions as measures of social capital in financial markets.

What are the differences in the perceptions of insider trading among different countries? Are the judgments of students similar to those of finance professional? Are rules of fairness in financial markets similar to rules of fairness in non-financial markets?

I use surveys to elicit rules of fairness from two segments of the community, finance professionals and university students, in eight countries, Australia, India, Israel, Italy, the Netherlands, Tunisia, Turkey and the U.S. I find that majorities of professionals and students in the U.S., the Netherlands, Israel and Australia consider insider trading unfair while majorities of students and substantial portions of professionals in India, Tunisia, Italy and Turkey consider insider trading acceptable. Students are more lenient than professionals in their ratings of insider trading in all countries. I also find that rules of fairness for trading stocks are different from rules of fairness for trading cars. For example, students in Tunisia and Turkey judge sellers of cars who have inside information about defective transmissions as less fair than they are judged by students in the U.S. and the Netherlands. But students in Tunisia and Turkey judge sellers of stocks based on inside information as more fair than they are judged by students in the U.S. and the Netherlands.

ethics, fairness, international, trading, insider trading, enforcement

Abstract:
The proposition that investors are overconfident about their valuation and trading skills can explain high observed trading volume. With biased self-attribution, the level of investor overconfidence and thus trading volume varies with past returns. We test the trading volume predictions of formal overconfidence models and find that share turnover is positively related to lagged returns for many months. The relationship holds for both market-wide and individual security turnover, which we interpret as evidence of investor overconfidence and the disposition effect, respectively. Security volume is more responsive to market return shocks than to security return shocks, and both relationships are more pronounced in small-cap stocks and in earlier periods where individual investors hold a greater proportion of shares. (JEL G11, G12)

Abstract:
Typical socially responsible investors tilt their portfolios toward stocks of companies with high scores on social responsibility characteristics and shun stocks of companies associated with tobacco, alcohol, gambling, firearms, and military or nuclear operations. Analyzing 1992-2007 returns of stocks rated on social responsibility, this study found that this tilt gave such investors an advantage over conventional investors. The study also found that shunning resulted in a disadvantage for such investors relative to conventional investors. The advantage from tilting toward stocks of companies with high social responsibility scores is largely offset by the disadvantage from the exclusion of stocks of shunned companies. Socially responsible investors can thus do both well and good by adopting the best-in-class method in constructing their portfolios: tilting toward stocks of companies with high scores on social responsibility characteristics but refraining from shunning stocks of any company.

Equity Investments, Other; Investment Theory, CAPM, APT, and Other Pricing Theories, Portfolio Management, Equity Strategies

Abstract:
We integrate appealing features of Markowitz's mean-variance portfolio theory (MVT) and Shefrin and Statman's behavioral portfolio theory (BPT) into a new mental accounting (MA) framework. Features of the MA framework include a mental accounting structure of portfolios, a definition of risk as the probability of failing to reach the threshold level in each mental account, and attitudes toward risk that vary by account. We demonstrate a mathematical equivalence between MVT, MA and risk management using VaR. The aggregate allocation across MA sub-portfolios is mean-variance efficient with short-selling. Short-selling constraints on mental accounts impose very minor reductions in certainty equivalents, only if binding for the aggregate portfolio, or setting utility losses from errors in specifying risk aversion coefficients in MVT applications. These generalizations of MVT and BPT via a united MA framework result in a fruitful connection between investor consumption goals and portfolio production.

Abstract:
Stocks, like houses, cars, watches, and other products, exude affect - that is, they are considered good or bad, beautiful or ugly; they are admired or disliked. Affect plays an overt role in the pricing of houses, cars, and watches, but according to standard financial theory, it plays no role in the pricing of financial assets. This article outlines a behavioral asset-pricing model in which expected returns are high not only when objective risk is high but also when subjective risk is high. High subjective risk comes with negative affect. Investors prefer stocks with positive affect, which boosts the prices of such stocks and depresses their returns.

Equity Investments, Fundamental Analysis and Valuation Models, Investment Theory, CAPM, APT, and Other Pricing Theories, Behavioral Finance

Abstract:
Ethics, fairness, trust, and freedom from corruption are parts of social capital, and social capital matters in financial markets. Investors consider not only the information they receive but also their trust in the accuracy of the information and the fairness of the markets in which to trade. Deficiencies in ethics and fairness mark all countries. But surveys of the perception among students and finance professionals of the fairness of insider trading in eight countries indicate that deficiencies are more pronounced in some countries than in others. Five factors are discussed that affect social capital: culture, globalization, income, education, and law enforcement.

Ethics and Professional Standards, Global Differences, Advocacy, Regulatory, and Legislative Issues, Advocacy Issues, Investment Industry, Other

Abstract:
Investment bankers, security analysts, traders, and other finance professionals often behave as if they lived in a cocoon. They need to recognize that they live under the community's rules of fairness as well as the market's rules. Through anecdotes, quotations, and survey reports, this article discusses how internal and external obstacles keep finance professionals from perceiving the community's rules of fairness - rules that often make their way into the law. Ultimately, those who fail to understand and follow the community rules of fairness are taking risks they would be wise to avoid.

Ethics and Professional Standards, Interpreting or Analyzing Ethical and Professional Standards, Other

Abstract:
The levels of diversification in U.S. investors' equity portfolios present a puzzle. Today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 300 stocks, but the average investor holds only 3 or 4 stocks. The diversification puzzle can be solved, however, in the context of behavioral portfolio theory. In behavioral portfolio theory, investors construct their portfolios as layered pyramids in which the bottom layers are designed for downside protection and the top layers are designed for upside potential. Risk aversion gives way to risk seeking at the uppermost layer as the desire to avoid poverty gives way to the desire for riches. But what motivates this behavior is the aspirations of investors, not their attitudes toward risk. Some investors fill the uppermost layer with the few stocks of an undiversified portfolio; others fill it with lottery tickets. Neither lottery buying nor undiversified portfolios are consistent with mean-variance portfolio theory, but both are consistent with behavioral portfolio theory.

Investment Theory, Behavioral Finance, Portfolio Theory, Portfolio Management, Asset Allocation

Abstract:
6/22/00: web retrieval--abstract only--Kathy
University of Washington
School of Business Administration
Journal of Financial and Quantitative Analysis
http://depts.washington.edu/jfqa/
Vol. 35, No. 2, June 2000

Behavioral Portfolio Theory

Hersh Shefrin and Meir Statman

Abstract:
We develop a positive behavioral portfolio theory (BPT) and explore its implications for portfolio construction and security design. The optimal portfolios of BPT investors resemble combinations of bonds and lottery tickets, consistent with Friedman and Savage's (1948) observation. We compare the BPT efficient frontier with the mean-variance efficient frontier and show that, in general, the two frontiers do not coincide. Optimal BPT portfolios are also different from optimal CAPM portfolios. In particular, the CAPM two-fund separation does not hold in BPT. We present BPT in a single mental account version (BPT-SA) and a multiple mental account version (BPT-MA). BPT-SA investors
integrate their portfolios into a single mental account, while BPT-MA investors segregate their portfolios into several mental accounts. BPT-MA portfolios resemble layered pyramids, where layers are associated with aspirations. We explore a two-layer portfolio where the low aspiration layer is designed to avoid poverty while the high aspiration layer is designed for a shot at
riches.

Abstract:
We know from empirical studies that stocks of small companies with high book-to-market ratios have provided higher returns than stocks of large companies with low book-to-market ratios. But do senior executives, outside directors and financial analysts believe that? We show that senior executives, outside directors and financial analysts surveyed annually by Fortune magazine rank companies as if they believe that good companies are large companies with low book-to-market ratios. They rank stocks as if they believe the opposite of what empirical research has demonstrated; they rank stocks as if they believe that good stocks are stocks of good companies. We argue that a misperception of the relationship between the quality of a company and the expected rate of return of its stock underlies the superior performance of stocks of small, high book-to-market companies and the weak relationship betweenrealized returns and beta.