This paper describes strategic behavior in a nonequilibrium model of asset pricing with heterogeneous sophistication. Both risk and return are increasing in the naïveté of investors in the market. Optimal investment involves considering the effect that naïve investors have on the market. Further, we derive a simple characterization of the asset price dynamics that results from an arbitrary comb...

Theory predicts that attribution bias creates overconfident traders and thus causes excessive trading in the market. This paper tests this prediction by comparing the trading behavior of individual investors in different market conditions. In a bull market, investors suffer more from attribution bias and therefore should be more overconfident and trade more excessively. Using the trading record...

In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by di erences in the shape of utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determin...

The levels of diversification in U.S. investors’ equity portfolios present a puzzle. Today’s optimal level of diversification, measured by the rules of mean–variance portfolio theory, exceeds 300 stocks, but the average investor holds only 3 or 4 stocks. The diversification puzzle can be solved, however, in the context of behavioral portfolio theory. In behavioral portfolio theory, investors co...

This study analyzes IQ’s influence on mutual fund choice. Using a comprehensive dataset of Finnish males, it finds that high-IQ investors are less likely to own balanced funds, actively managed funds, and funds marketed through a retail network. This behavior tends to reduce highIQ investors’ fund fees. Moreover, within each asset class and service category, and controlling for other investor a...

We present a theory of excess stock market volatility, in which market movements are due to trades by very large institutional investors in relatively illiquid markets. Such trades generate significant spikes in returns and volume, even in the absence of important news about fundamentals. We derive the optimal trading behavior of these investors, which allows us to provide a unified explanation...

In this paper I analyze investors’ reactions to changes in the expense ratios of equity mutual funds. I show that investment flows’ response to fees cannot be fully explained by looking at investors’ performance sensitivity. While performance sensitivity monotonically increases with past performance, price sensitivity does not: investors who buy top past performers seem to be “distracted” by th...

Optimism or pessimism of investors is one of the important characteristics that determine the investment behavior in financial markets. In this paper, we propose a model of investor optimism based on a fuzzy connective. The advantage of the proposed approach is that the influence of different levels of optimism can be studied by varying a single parameter. We implement our model in an artificia...

Investors significantly reduce their future returns by selecting mutual funds with higher fees, allured by higher past returns that do not predict future performance. This suboptimal behavior, which can roughly halve an investor’s retirement savings, is driven by two psychological factors. One factor is difficulty comprehending rate information, which is critical given that mutual fund fees and...

This paper studies international equity markets when some investors have private information that is valuable for trading in many countries simultaneously. We use a dynamic model of equity trading to show that global private information helps explain US investors’ trading behavior and performance. In particular, the model predicts global return chasing (positive co-movement of US investors’ net...