We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed-end mutual funds, and the Mehra-Prescott equity premium puzzle.

https://ms.mcmaster.ca/~grasselli/DeLongShleiferSummersWaldmann90.pdf

Noise Trader Risk in Financial Markets

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors’ confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations ~“momentum”!, short-run earnings “drift,” but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. IN RECENT YEARS A BODY OF evidence on security returns has presented a sharp challenge to the traditional view that securities are rationally priced to ref lect all publicly available information. Some of the more pervasive anomalies can be classified as follows ~Appendix A cites the relevant literature!: 1. Event-based return predictability ~public-event-date average stock returns of the same sign as average subsequent long-run abnormal performance! 2. Short-term momentum ~positive short-term autocorrelation of stock returns, for individual stocks and the market as a whole!

/pdf/investor-psychology-and-security-market-under-and-108faczcym.pdf

Investor Psychology and Security Market Under- and Overreactions

Theoretical models of financial markets built on the assumption that some investors are overconfident yield one central prediction: overconfident investors will trade too much. We test this prediction by partitioning investors on the basis of a variable that provides a natural proxy for overconfidence--gender. Psychological research has established that men are more prone to overconfidence than women. Thus, models of investor overconfidence predict that men will trade more and perform worse than women. Using account data for over 35,000 households from a large discount brokerage firm, we analyze the common stock investments of men and women from February 1991 through January 1997. Consistent with the predictions of the overconfidence models, we document that men trade 45 percent more than women and earn annual risk-adjusted net returns that are 1.4 percent less than those earned by women. These differences are more pronounced between single men and single women; single men trade 67 percent more than single women and earn annual risk-adjusted net returns that are 2.3 percent less than those earned by single women.

https://papers.ssrn.com/sol3/Delivery.cfm/98110615.pdf?abstractid=139415&rulid=175370&mirid=3

Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment

We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors' confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrelations (momentum), short-run earnings drift, but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate financial policy. 
Prepublication version available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2017

Presentation Slides for 'Investor Psychology and Security Market Under and Overreactions'

Theoretical models predict that overconedent investors trade excessively We test this prediction by partitioning investors on gender Psychological research demonstrates that, in areas such as enance, men are more overconedent than women Thus, theory predicts that men will trade more excessively than women Using account data for over 35,000 households from a large discount brokerage, we analyze the common stock investments of men and women from February 1991 through January 1997 We document that men trade 45 percent more than women Trading reduces men’s net returns by 265 percentage points a year as opposed to 172 percentage points for women It’s not what a man don’t know that makes him a fool, but what he does know that ain’t so Josh Billings, nineteenth century American humorist It is difecult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors Rational investors make periodic contributions and withdrawals from their investment portfolios, rebalance their portfolios, and trade to minimize their taxes Those possessed of superior information may trade speculatively, although rational speculative traders will generally not choose to trade with each other It is unlikely that rational trading needs account for a turnover rate of

/pdf/boys-will-be-boys-gender-overconfidence-and-common-stock-2ctwfizezu.pdf

Boys will be Boys: Gender, Overconfidence, and Common Stock Investment

Individual investor risk aversion and investment portfolio composition

In recent years, a substantial amount of attention has been directed in the literature of economics and finance to the question of the investment behavior and portfolio performance of institutional investors.' Those investigations are natural ones, both because the relevant portfolio data are reasonably accessible and because the institutions involved are rapidly growing accumulators and traders of corporate equity securities. The traditional bulwark of the American equity marketplace-the individual investor-however, has been an object of scrutiny only in very aggregative terms. The trend of his apparent withdrawal from direct market participation has been amply documented,2 and the appropriate alarums expressed,3 but the causes of that phenomenon remain almost entirely conjectural. Indeed, virtually all

Patterns of Investment Strategy and Behavior Among Individual Investors

The individual investor: attributes and attitudes

A number of investigators have reported that January stock returns in the U.S. exceed returns for other months of the year. This paper documents a similar finding for Canadian stocks over the period 1951-1980. However, Canada did not introduce a capital gains tax until 1973 and the paper reports that January returns in Canada exceed returns for other months of the year before and after this date. Thus, these data do not support the tax-loss-selling-pressure hypothesis as the entire explanation for the turnof-the-year effect in stock returns, nor, by implication, do they support the tax-lossselling-pressure hypothesis as the complete explanation for the "small firm" effect in U.S. stocks returns. RECENTLY KEIM [9] has reported that returns on NYSE and ASE firms with small market values exceed, by significant margins, returns on firms with large market values. This result was previously reported by Banz [1] and Reinganum [11], but Keim's analysis shows that most of the excess return for small firms is concentrated in January.' Indeed, it is concentrated in the first two weeks in January. Roll [13] also documents this phenomenon and investigates a number of possible explanations for it.2 After rejecting several possible "nonexploitable" explanations, Roll is left with year-end tax-loss selling pressure, of the sort discussed by Branch [2], Dyl [5], and Givoly and Ovadia [6], as the most likely explanation of this result. According to the tax-loss-selling-pressure hypothesis, toward the end of the year stockholders sell stocks that have declined in price during the year. Investors do this to take advantage of the opportunity to write-off capital losses against ordinary income in computing their federal income taxes. The year-end sell-off exerts downward pressure on stock prices. As soon as the tax and calendar year ends, the selling pressure is relieved and stock prices quickly rebound to their "equilibrium" levels. Roll [13] presents some evidence consistent with this hypothesis. Specifically, he finds a negative correlation between stock returns in January and returns over the previous 12 months. That is, stocks that decrease in value during the year tend to be big gainers in January. Roll also finds that

The Turn‐of‐the‐Year in Canada

dividends-irrelevance proposition of Miller and Modigliani [28], and the more recent empirical investigations by Friend and Puckett [14], Diamond [7], and Black and Scholes [1], the dispute as to a dividend effect has continued. Although the issue would appear even yet not to be fully resolved, the character of the debate was modified substantially by the Miller-Modigliani demonstration that, in a perfect capital market, dividend policy cannot matter-given an established investment policy. Since then, the emphasis of conjectures that dividends nonetheless may still matter in practice has shifted to a concern primarily with market imperfections as an underlying cause. We offer here some evidence which bears on the potential role of one of the key such imperfections commonly cited: differences in the rates of tax paid by different investors on their dividend receipts. In particular, we shall address the question as to whether a tax-induced "'clientele" effect seems present in fact in the equities marketplace. Since treatments of the other side of the dividend coin-the acceptability criteria for investment projects financed by retained earnings-have also generally contended that investor tax rates bear on the problem [3][12][23], there are a number of ramifications for managerial decisions if a clientele array can be discerned.

Gary G. Schlarbaum

Papers

Individual investor risk aversion and investment portfolio composition

Patterns of Investment Strategy and Behavior Among Individual Investors

The individual investor: attributes and attitudes

The Turn‐of‐the‐Year in Canada

Some direct evidence on the dividend clientele phenomenon