Investor Psychology in Capital Markets: Evidence and Policy Implications

Abstract

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 policies. Especially, government should avoid actions that exacerbate investor biases.

JEL Classification: G12, G14, G18, G28, G38, M41