Essays on Behavioral Finance

Princeton University, Princeton NJ

Investigators

Abstract

This research contributes to the two central tenets of behavioral finance: limits to arbitrage by professional traders, and cognitive biases of individual investors. It consists of three projects. The first project provides an innovative explanation for the persistence of mispricing by highlighting the difficulty professional traders face in synchronizing their corrective trading activity. Price correction is delayed because no individual trader wants to trade early if others decide to postpone their trade. In this setting, behavioral traders (whose trading is driven by psychological factors) will have an effect on the price process because their actions are not immediately undone by professional traders. The second project looks at a special form of mispricing: a growing bubble. It is an experimental study that tests the prediction that rational arbitrageurs would rather ride a bubble than trade against it. This project also attempts to analyze the extent to which market transparency of order flow and trading volume affects the persistence of mispricing. The novelty of this laboratory experiment is that, in contrast to the previous literature, we expect that bubbles will not die away even after subjects have become more familiar with the game. The third project explicitly models some behavioral biases. The study provides a new microfoundations based explanation for the "disposition effect" which states that individual investors are reluctant to realize losses. The study will show that this reluctance follows naturally for individuals with time-inconsistent preferences over capital gains and losses. The advantage of our approach is that it is more parsimonious and hence is easier to test. This research has significant normative implications. Mispricing in general, and bubbles in particular, are not only responsible for the redistribution of billions of dollars, but their bursting causes market uncertainty and can even lead to recessions. The recent technology bubble on the NASDAQ market is a vivid reminder of these risks. The proposed projects will enhance the state of our knowledge by scrutinizing rational and psychological forces that drive financial markets and by highlighting the importance of transparency of trades.