A Survey of Behavioral Finance

Chapter 18

A SURVEY OF BEHAVIORAL FINANCE °

NICHOLAS BARBERIS University of Chicago RICHARD THALER University of Chicago

Contents Abstract Keywords 1. Introduction 2. Limits to arbitrage

2.1. Market efficiency 2.2. Theory 2.3. Evidence 2.3.1. Twin shares 2.3.2. Index inclusions 2.3.3. Internet carve-outs

3. Psychology

3.1. Beliefs 3.2. Preferences 3.2.1. Prospect theory 3.2.2. Ambiguity aversion

4. Application: The aggregate stock market

4.1. The equity premium puzzle 4.1.1. Prospect theory 4.1.2. Ambiguity aversion 4.2. The volatility puzzle 4.2.1. Beliefs 4.2.2. Preferences

5. Application: The cross-section of average returns

5.1. Belief-based models

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We are very grateful to Markus Brunnermeier, George Constantinides, Kent Daniel, Milt Harris, Ming Huang, Owen Lamont, Jay Ritter, Andrei Shleifer, Jeremy Stein and Tuomo Vuolteenaho for extensive comments. Handbook of the Economics of Finance, Edited by G.M. Constantinides, M. Harris and R. Stulz © 2003 Elsevier Science B.V All rights reserved .

1052 5.2. Belief-based models with institutional frictions 5.3. Preferences

N. Barberis and R. Thaler

6. Application: Closed-end funds and comovement

6.1. Closed-end funds 6.2. Comovement

7. Application: Investor behavior

7.1. 7.2. 7.3. 7.4. 7.5. Insufficient diversification Naive diversification Excessive trading The selling decision The buying decision

8. Application: Corporate finance

8.1. Security issuance, capital structure and investment 8.2. Dividends 8.3. Models of managerial irrationality

9. Conclusion Appendix A References

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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:...