Behavior Based Manipulation

Abstract

If investors are not fully rational, what can smart money do? This paper provides an example in which smart money can strategically take advantage of investors behavioral biases and manipulate the price process to make profit. The paper considers three types of traders, behavior-driven investors who have two behavioral biases (momentum trading and dispositional effect), arbitrageurs, and a manipulator who can influence asset prices. We show that, due to the investors behavioral biases and the limit of arbitrage, the manipulator can profit from a "pump and dump" trading strategy by accumulating the speculative asset while pushing the asset price up, and then selling the asset at high prices. Since nobody has private information, manipulation investigated here is completely trade-based. The paper also endogenously derives several asset pricing anomalies, including the high volatility of asset prices, momentum and reversal.