Herd Behavior

In: Business and Management

Submitted By jialan
Words 33427
Pages 134

Investor Psychology and Asset Pricing
The basic paradigm of asset pricing is in vibrant f lux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models. The best plan is . . . to profit by the folly of others.
— Pliny the Elder, from John Bartlett, comp.
Familiar Quotations, 9th ed. 1901.
IN THE MUDDLED DAYS BEFORE THE RISE of modern finance, some otherwisereputable economists, such as Adam Smith, Irving Fisher, John Maynard
Keynes, and Harry Markowitz, thought that individual psychology affects prices.1 What if the creators of asset-pricing theory had followed this thread?
Picture a school of sociologists at the University of Chicago proposing the
Deficient Markets Hypothesis: that prices inaccurately ref lect all available information. A brilliant Stanford psychologist, call him Bill Blunte, invents the Deranged Anticipation and Perception Model ~or DAPM!, in which proxies for market misvaluation are used to predict security returns. Imagine the euphoria when researchers discovered that these mispricing proxies ~such
* Hirshleifer is from the Fisher College of Business, The Ohio State University. This survey was written for presentation at the American Finance Association Annual Meetings in New
Orleans, January, 2001. I especially thank the editor, George Constantinides, for valuable comments and suggestions. I also thank Franklin Allen, the discussant, Nicholas Barberis, Robert

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