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Abstract:
Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: Limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then present a number of behavioral finance applications: To the aggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate finance. We close by assessing progress in the field and speculating about its future course.

Abstract:
Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then present a number of behavioral finance applications: to the aggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate finance. We close by assessing progress in the field and speculating about its future course.

behavioral finance, market efficiency, limits to arbitrage, psychology, investor behavior

Abstract:
We propose a new framework for pricing assets, derived in part from the traditional consumption-based approach, but which also incorporates two long-standing ideas in psychology: prospect theory, and evidence on how prior outcomes affect risky choice. Consistent with prospect theory, the investor in our model derives utility not only from consumption levels but also from changes in the value of his financial wealth. He is much more sensitive to reductions in wealth than to increases, the ``loss-aversion'' feature of prospect utility. Moreover consistent with experimental evidence, the utility he receives from gains and losses in wealth depends on his prior investment outcomes; prior gains cushion subsequent losses -- the so-called 'house-money' effect -- while prior losses intensify the pain of subsequent shortfalls. We study asset prices in the presence of agents with preferences of this type, and find that our model reproduces the high mean, volatility, and predictability of stock returns. The key to our results is that the agent's risk-aversion changes over time as a function of his investment performance. This makes prices much more volatile than underlying dividends and together with the investor's loss-aversion, leads to large equity premia. Our results obtain with reasonable values for all parameters.

Abstract:
We propose a new framework for pricing assets, derived in part from the traditional consumption-based approach, but which also incorporates two long-standing ideas in psychology: the prospect theory of Kahneman and Tversky (1979), and the evidence of Thaler and Johnson (1990) and others on the influence of prior outcomes on risky choice. Consistent with prospect theory, the investor in our model derives utility not only from consumption levels but also from changes in the value of his financial wealth. He is much more sensitive to reductions in wealth than to increases, the "loss-aversion" feature of prospect utility. Moreover, consistent with experimental evidence, the utility he receives from gains and losses in wealth depends on his prior investment outcomes; prior gains cushion subsequent losses -- the so-called "house-money" effect -- while prior losses intensify the pain of subsequent shortfalls. We study asset prices in the presence of agents with preferences of this type and find that our model reproduces the high mean, volatility, and predictability of stock returns. The key to our restuls is that the agent's risk-aversion changes over time as a function of his investment performance. This makes prices much more volatile than underlying dividends, and together with the investor's loss-aversion, leads to large equity premia. Our results obtain with reasonable values for all parameters.

Abstract:
We study asset prices in an economy where some investors classify risky assets into different styles and move funds back and forth between these styles depending on their relative performance. Our assumptions imply that news about one style can affect the prices of other apparently unrelated styles, that assets in the same style will comove too much while assets in different styles comove too little, and that high average returns on a style will be associated with common factors for reasons unrelated to risk. They also lead to a rich pattern of own- and cross-autocorrelations, sample premia that can be very different from true premia, and imply that style momentum strategies will be profitable. We use our model to shed light on many puzzling features of the data.

Abstract:
We study asset prices in an economy where some investors classify risky assets into different styles and move funds back and forth between these styles depending on their relative performance. Our assumptions imply that news about one style can affect the prices of other apparently unrelated styles, that assets in the same style will comove too much while assets in different styles comove too little, and that high average returns on a style will be associated with common factors for reasons unrelated to risk. They also lead to a rich pattern of own- and cross-autocorrelations, sample premia that can be very different from true premia, and imply that style momentum strategies will be profitable. We use our model to shed light on many puzzling features of the data.

Abstract:
A number of studies have identified patterns of positive correlation of returns, or comovement, among different traded securities. We distinguish three views of such co- movement. The traditional "fundamentals" view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash ows or discount rates. "Category-based" comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of "habitat-based" comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem.We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index. Index changes are noteworthy because they change a stock's category and investor clientele (habitat), but do not change its fundamentals. We find that when a stock is added to the index, its beta and R-squared with respect to the index increase, while its beta with respect to stocks outside the index falls. The converse happens when a stock is deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that these non-traditional views may help explain other instances of comovement in the data.

Abstract:
We consider two broad views of return comovement: the traditional view, derived from frictionless economies with rational investors, which attributes it to comovement in news about fundamental value, and an alternative view, in which market frictions or noise-trader sentiment delink it from comovement in fundamentals. Building on Vijh (1994), we use data on inclusions into the S&P 500 to distinguish these views. After inclusion, a stock's beta with the S&P goes up. In bivariate regressions which control for the return of non-S&P stocks, the increase in S&P beta is even larger. These results are generally stronger in more recent data. Our findings cannot easily be explained by the fundamentals-based view and provide new evidence in support of the alternative friction- or sentiment-based view.

Abstract:
A number of studies have identified patterns of positive correlation of returns, orcomovement, among different traded securities. We distinguish three views of such comovement. The traditional \fundamentals" view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash flows or discount rates. \Category-based" comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of \habitat-based" comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem. We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index.Index changes are noteworthy because they change a stock's category and investorclientele (habitat), but do not change its fundamentals. We find that when a stock isadded to the index, its beta and R-squared with respect to the index increase, while itsbeta with respect to stocks outside the index falls. The converse happens when a stockis deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that thesenon-traditional views may help explain other instances of comovement in the data.

Abstract:
A number of studies have identifed patterns of positive correlation of returns, or comovement, among different traded securities. We distinguish three views of such comovement. The traditional 'fundamentals' view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash flows or discount rates. 'Category-based' comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of 'habitat-based' comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem. We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index. Index changes are noteworthy because they change a stock's category and investor clientele (habitat), but do not change its fundamentals. We find that when a stock is added to the index, its beta and R-squared with respect to the index increase, while its beta with respect to stocks outside the index falls. The converse happens when a stock is deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that these non-traditional views may help explain other instances of comovement in the data.

Abstract:
A number of studies have identifed patterns of positive correlation of returns, or comovement, among different traded securities. We distinguish three views of such comovement. The traditional "fundamentals" view explains the comovement of securities through positive correlations in the rational determinants of their values, such as cash flows or discount rates. "Category-based" comovement occurs when investors classify different securities into the same asset class and shift resources in and out of this class in correlated ways. A related phenomenon of "habitat-based" comovement arises when a group of investors restricts its trading to a given set of securities, and moves in and out of that set in tandem.

We present models of each of the three types of comovement, and then assess them empirically using data on stock inclusions into and deletions from the S&P 500 index. Index changes are noteworthy because they change a stock's category and investor clientele (habitat), but do not change its fundamentals. We find that when a stock is added to the index, its beta and R-squared with respect to the index increase, while its beta with respect to stocks outside the index falls. The converse happens when a stock is deleted. These results are broadly supportive of the category and habitat views of comovement, but not of the fundamentals view. More generally, we argue that these non-traditional views may help explain other instances of comovement in the data.

Abstract:
We examine how the evidence of predictability in asset returns affects optimal portfolio choice for investors with long horizons. Particular attention is paid to estimation risk, or uncertainty about the true values of model parameters. We find that even after incorporating parameter uncertainty, there is enough predictability in returns to make investors allocate substantially more to stocks, the longer their horizon. Moreover, the weak statistical significance of the evidence for predictability makes it important to take estimation risk into account; a long-horizon investor who ignores it may over-allocate to stocks by a sizeable amount.

Abstract:
We examine how the evidence of predictability in asset returns affects optimal portfolio choice for investors with long horizons. Particular attention is paid to estimation risk, or uncertainty about the true values of model parameters. We find that even after incorporating parameter uncertainty, there is enough predictability in returns to make investors allocate substantially more to stocks, the longer their horizon. Moreover, the weak statistical significance of the evidence for predictability makes it important to take estimation risk into account; a long-horizon investor who ignores it may over-allocate to stocks by a sizeable amount.

Abstract:
We argue that narrow framing, whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making under risk than previously realized. To demonstrate this, we present evidence on typical attitudes to independent monetary gambles with both large and small stakes and show that across a wide range of utility functions, including all expected utility and many non-expected utility specifications, the only ones that can easily capture these attitudes are precisely those exhibiting narrow framing. Our analysis also makes predictions about the kinds of preferences that might be able to address the stock market participation and equity premium puzzles. We illustrate these predictions in simple portfolio choice and equilibrium settings.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We argue that narrow framing, whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making under risk than previously realized. To demonstrate this, we present evidence on typical attitudes to independent monetary gambles with both large and small stakes and show that across a wide range of utility functions, including all expected utility and many non-expected utility specifications, the only ones that can easily capture these attitudes are precisely those exhibiting narrow framing. Our analysis also makes predictions about the kinds of preferences that might be able to address the stock market participation and equity premium puzzles. We illustrate these predictions in simple portfolio choice and equilibrium settings.

risk aversion, framing, loss aversion, stock market participation, equity premium

Abstract:
We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be overpriced, and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

Abstract:
We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be overpriced, and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

prospect theory, asset pricing, skewness, under-diversification

Abstract:
One of the most striking portfolio puzzles is the "disposition effect": the tendency of individuals to sell stocks in their portfolios that have risen in value since purchase, rather than fallen in value. Perhaps the most prominent explanation for this puzzle is based on prospect theory. Despite its prominence, this explanation has received little formal scrutiny. We take up this task, and analyze the trading behavior of investors with prospect theory preferences. We find that, at least for the simplest implementation of prospect theory, the link between these preferences and the disposition effect is not as obvious as previously thought: in some cases, prospect theory does indeed predict a disposition effect, but in others, it predicts the opposite. We provide intuition for these results, and identify the conditions under which the disposition effect holds or fails. We also discuss the implications of our results for other disposition-type effects that have been documented in settings such as the housing market, futures trading, and executive stock options.

Abstract:
One of the most striking portfolio puzzles is the disposition effect: the tendency of individuals to sell stocks in their portfolios that have risen in value since purchase, rather than fallen in value. Perhaps the most prominent explanation for this puzzle is based on prospect theory. Despite its prominence, this hypothesis has received little formal scrutiny. We take up this task, and analyze the trading behavior of investors with prospect theory preferences. Surprisingly, we find that, in its simplest implementation, prospect theory often predicts the opposite of the disposition effect. We provide intuition for this result, and identify the conditions under which the disposition effect holds or fails. We also discuss the implications of our results for other disposition-type effects that have been documented in settings such as the housing market, futures trading, and executive stock options.

disposition effect, prospect theory

Abstract:
We argue that "narrow framing," whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making than previously realized. Our starting point is the evidence that people are often averse to a small, independent gamble, even when the gamble is actuarially favorable. We find that a surprisingly wide range of utility functions, including many non-expected utility specifications, have trouble explaining this evidence; but that this difficulty can be overcome by allowing for narrow framing. Our analysis makes predictions as to what kinds of preferences can most easily address the stock market participation puzzle, as well as other related financial puzzles. We confirm these predictions in a simple portfolio choice setting.

risk aversion, framing, loss aversion, stock market participation

Abstract:
Casino gambling is a hugely popular activity around the world, but there are still very few models of why people go to casinos or of how they behave when they get there. In this paper, we show that prospect theory can offer a surprisingly rich theory of gambling, one that captures many features of actual gambling behavior. First, we demonstrate that, for a wide range of parameter values, a prospect theory agent would be willing to gamble in a casino, even if the casino only offers bets with zero or negative expected value. Second, we show that prospect theory predicts a plausible time inconsistency: at the moment he enters a casino, a prospect theory agent plans to follow one particular gambling strategy; but after he enters, he wants to switch to a different strategy. The model therefore predicts heterogeneity in gambling behavior: how a gambler behaves depends on whether he is aware of the time-inconsistency; and, if he is aware of it, on whether he is able to commit, in advance, to his initial plan of action.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
Casino gambling is a hugely popular activity around the world, but there are still very few models of why people go to casinos or of how they behave when they get there. In this paper, we show that prospect theory can offer a surprisingly rich theory of gambling, one that captures many features of actual gambling behavior. First, we demonstrate that, for a wide range of parameter values, a prospect theory agent would be willing to gamble in a casino, even if the casino only offers bets with zero or negative expected value. Second, we show that prospect theory predicts a plausible time inconsistency: at the moment he enters a casino, a prospect theory agent plans to follow one particular gambling strategy; but after he enters, he wants to switch to a different strategy. The model therefore predicts heterogeneity in gambling behavior: how a gambler behaves depends on whether he is aware of the time-inconsistency; and, if he is aware of it, on whether he is able to commit, in advance, to his initial plan of action.

gambling, prospect theory, time inconsistency, probability weighting

Abstract:
We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.

Abstract:
We review a recent approach to understanding the equity premium puzzle. The key elements of this approach are loss aversion and narrow framing, two well-known features of decision-making under risk in experimental settings. In equilibrium, models that incorporate these ideas can generate a large equity premium and a low and stable risk-free rate, even when consumption growth is smooth and only weakly correlated with the stock market. Moreover, they can do so for parameter values that correspond to sensible attitudes to independent monetary gambles. We conclude by suggesting some possible directions for future research.

loss aversion, narrow framing, equity premium

Abstract:
Experimental work on decision-making shows that, when people evaluate risk, they often engage in narrow framing: that is, in contrast to the prediction of traditional utility functions defined over wealth or consumption, they often evaluate risks in isolation, separately from other risks they are already facing. While narrow framing has many potential applications to understanding attitudes to real-world risks, there does not currently exist a tractable preference specification that incorporates it into the standard framework used by economists. In this paper, we propose such a specification and demonstrate its tractability in both consumption/portfolio choice and equilibrium settings.

behavioral finance, diversification, equity premium, utility functions

Abstract:
Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements; and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment that is, of how investors form beliefs that is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.

Abstract:
Recent empirical research inn finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements; and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment - that is, of how investors form beliefs - that is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.

Abstract:
We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss averse over the fluctuations of individual stocks that they own. Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: in that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross-section which can, to some extent, be captured by a commonly used multifactor model.

Abstract:
We study equilibrium firm-level stock returns in two economies: one in which investors are loss averse over the fluctuations of their stock portfolio and another in which they are loss averse over the fluctuations of individual stocks that they own. Both approaches can shed light on empirical phenomena, but we find the second approach to be more successful: in that economy, the typical individual stock return has a high mean and excess volatility, and there is a large value premium in the cross-section which can, to some extent, be captured by a commonly used multifactor model.

Abstract:
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.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We use a survey of 452 Russian shops, most of which were privatized between 1992 and 1993, to measure the importance of alternative channels through which privatization promotes restructuring. Restructuring is measured as capital renovation, change in suppliers, increase in hours that stores stay open, and layoffs. There is strong evidence that the presence of new owners and new managers raises the likelihood of restructuring. In contrast, there is no evidence that equity incentives of old managers promote restructuring. The evidence points to the critical role that new human capital plays in economic transformation.

Abstract:
We use a survey of 452 Russian shops, most of which were privatized between 1992 and 1993, to measure the importance of alternative channels through which privatization promotes restructuring. Restructuring is measured as major renovation, a change in suppliers, an increase in hours stores stay open, and layoffs. There is strong evidence that the presence of new owners and new managers raises the likelihood of restructuring. In contrast, there is no evidence that equity incentives of old managers promote restructuring. The evidence points to the critical role new human capital plays in economic transformation.

Abstract:
A number of recent studies have testified to the benefits of private as opposed to state ownership of firms. One research strand compares private and state firms in the same line of activity, such as air transport or railroads, and finds the former to be more efficient (see Boardman and Vining, 1989, for a survey). A second strand reveals the improvements in a given company's operations following privatization (see Megginson et al., 1994). A third strand documents the lower cost of contracting public services to private suppliers than providing it publicly (see Donahue, 1989). This research makes a convincing case for the greater efficiency of private ownership.