Wednesday, June 26, 2013

Some essential papers in behavioral finance

Nobody quite knows what "behavioral finance" means, and that's a good thing. Essentially, modern finance theory began with the notion of "efficient markets", risk-return tradeoffs, and complete markets. That theory remains the mainstream in academic circles. But at least since the 80s, finance researchers have been noticing "anomalies" in the predictions of efficient-market theories and mainstream risk models. Attempts to explain these anomalies, or to dig up more of them, loosely fall under the heading of "behavioral finance", probably because in the 80s, behavioral economics was just becoming popular. But behavioral finance isn't just behavioral econ applied to finance; it includes a whole big eclectic mix of ideas and observations about market institutions, overall market movements, and information processing, and at this point is really just "anything that isn't efficient-markets finance". The literature is really all over the place. But here are a few foundational papers to get you started.

"Speculative Investor Behavior in a Stock Market With Heterogeneous Expectations", by J.M. Harrison and David Kreps (1978)
This paper came out at a time when devotion to extreme rationality was de rigeur in most economic circles. Harrison and Kreps assume that investors have extreme irrationality, being so overconfident in their differing beliefs that they never reach agreement. As a result, financial assets carry a "speculative premium", because holding an asset gives you the option to resell it in the future to someone more optimistic than yourself. This paper really spawned the whole "overconfidence" literature, and the "heterogeneous beliefs" literature too. When Tom Sargent called himself a "Harrison-Kreps Keynesian", this is the paper he was talking about.

"On the Impossibility of Informationally Efficient Markets", by Sanford Grossman and Joseph Stiglitz (1980)
This paper basically killed the "strong form" of the Efficient Markets Hypothesis. The intuition has become so common that you might even be surprised that someone wrote a paper on it. Basically, if all information is already incorporated in market prices, then there's no incentive for anyone to go gather information. In the model in this paper, prices are just "wrong" enough to justify the cost of going out and finding new information. But we all know that in the real world this is highly unlikely to be true. The idea of "information externalities" in financial markets comes in part from this paper.

"Do Stock Prices Move Too Much to be Justified By Subsequent Changes in Dividends?", by Robert Shiller (1981)
What if your weather forecaster kept switching his one-week-ahead forecast between 85 degrees Fahrenheit and 15 degrees Fahrenheit? You would fire that forecaster. But if you think stock markets are efficient, then stock markets should be the best possible forecaster of future dividends, since dividends are the "fundamental value" of stocks. In this famous paper, Shiller showed that stock prices fluctuate more than the eventual dividends that they were supposed to have forecast. Whatever is making stock prices gyrate, it doesn't look rational.

"Information, Trade, and Common Knowledge", by Paul Milgrom and Nancy Stokey (1982)
This paper might not strike you as behavioral, since it discusses hyper-rational behavior in an efficient market, and was written by the wife of Robert Lucas. But actually, this paper is about the fact that rational-expectations theory almost certainly can't explain real-world markets. The basic reason: if everyone were rational, and this was common knowledge, there wouldn't be much trading, because everyone would always be second-guessing their counterparty (e.g. "Why would you sell me this stock at $100 if you didn't think it was worth less than $100?", and so on). The fact that we see such huge trade volumes in real-world markets means that there is probably a lot of irrationality out there.

"Does the Stock Market Overreact?", by Werner DeBondt and Richard Thaler (1985)
Here's an easy way to beat the stock market: Buy the stocks that did the worst over the past 5 years, and hold onto them for another 5. Ta-da! DeBondt and Thaler show that this strategy makes more money than just holding an index fund. Under Efficient Markets theory, that should not be the case. This is known as the "long-term reversal" anomaly.

"Bubbles and Crashes in Experimental Asset Markets", by Vernon Smith, Gerry Suchanek, and Arlington Williams (1988)
The paper that started essentially all of experimental finance. Basically, the authors put some college kids in the simplest possible artificial market setup. It should have been a no-brainer, but what happened, again and again and again, was a giant bubble and crash.

"Noise Trader Risk in Financial Markets", by J. Bradford De Long, Andrei Shleifer, Lawrence H. Summers, Robert J. Waldmann (1990)
What would you do if a horde of zombies was running your way? If there were only a few you might stand and fight, but if there were enough zombies you might have no choice but to turn around and run in the same direction, essentially becoming a zombie yourself. This is the basic idea of "noise trader" models, which show how smart, rational traders can be overwhelmed by irrational hordes of "noise traders". In a bubble situation, the smart money finds it necessary to imitate the dumb money, and smart investors "ride the bubble", making the eventual crash even bigger.

"Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency", by Narasimhan Jegadeesh and Sheridan Titman (1993)
This paper is kind of the mirror image of the DeBondt and Thaler paper above. Jegadeesh and Titman show that if you buy the stocks that performed best over the past three to twelve months and hold onto them for another few months, you will beat the market. This is the famous "momentum anomaly", and represents a severe violation of the Efficient Markets Hypothesis. Together with the long-term reversal anomaly, it implies a market where stock prices regularly "overshoot" and then return to a more reasonable level. 

"Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment", by Brad Barber and Terrence Odean (2001)
Guess what? You really suck at investing. And the reason is that you trade too often, ignoring the costs you pay every time you trade. Why do you do this? Well, maybe because you are overconfident, and you think (wrongly) that you know better than the market how to interpret the latest piece of news or data. If this is the reason, then you are more likely to over-trade if you are a man than if you are a woman, since psychologists have shown that men on average display more overconfidence than women. And guess what? The evidence says that this is true. Looking at data from a discount brokerage, Barber and Odean found that male individual investors trade more than female ones, and incur greater losses as a result.

"Hedge Funds and the Technology Bubble", by Markus K. Brunnermeier and Stefan Nagel (2004)
If "noise trader" models are right, then "smart money" investors like hedge finds should ride bubbles instead of trying to pop them. Looking at data on hedge fund behavior during the tech bubble, Brunermeier and Nagel find that this is exactly what happened.

"Subjective Expectations and Asset-Return Puzzles", by Martin Weitzman (2007)
One long-standing puzzle in financial economics was the fact that stocks tend to have much better returns than bonds, despite not having that much more risk. But as Martin Weitzman shows in this paper (with some fearsome math), the risk of stocks looks a lot larger if investors aren't sure about the underlying structure of the world. Which, of course, they aren't.

Anyway, these papers will get you started thinking about behavioral finance! Obviously there is much newer stuff, and topics other than's a big and growing field. A very exciting one in which to work, if you ask me...

Update: People have been asking "Why no prospect theory?" Obviously, "Prospect Theory: An Analysis of Decision Under Risk" (Daniel Kahneman and Amos Tversky, 1979) is one of the most important, if not the most important, behavioral econ papers ever written. And people have certainly tried to apply that theory in finance.


  1. Anonymous7:16 PM

    Thanks, this is a very helpful list!

  2. Anonymous9:06 PM

    Skumbag Noah leaves for over a week, what about the pleasure I enjoy from reading you work did you take that into account when planning your extended hiatus Bring back the Thursday roundup and all will be forgiven.

    1. AUGGGGHHHHH, my greatest nightmare...demanding readers!

      OK, Thursday Roundup will make a reappearance...

    2. Anonymous12:03 AM

      Yes!!! Christmas in July err late June. And I believe some behavioral psychologists from across the rigorous scientific pond will agree this is the start of some positive conditioning. I joyfully await your next roundup, and will spend the interim browsing your listed behavioral finance papers

      And continue to wish my econ professors were prolific bloggers instead of prolifically elderly.

      And how bad is it that I find econ blogs much more fascinating than econ hw... hasn't affected my grades yet but undergrad econ is pretty much a joke anyways. I keep hoping for insight and all I get are some silly platitudes wrapped in ridiculous assumptions. Why is it Noah, that when a Biologist informs you about his research, or when a physicist attempts to explain some new theory the average layman listens, yet when economists come out with new work we instantly dismiss all that does not conform to our world view, I say politics is the poison that will plague the usefulness of economics.

      Thanks again

    3. And how bad is it that I find econ blogs much more fascinating than econ hw

      I think most people do! Econ assumptions rarely get challenged in the classroom...but on blogs it's a free-for-all.

      we instantly dismiss all that does not conform to our world view, I say politics is the poison that will plague the usefulness of economics.

      I agree...the Derp is mighty!

    4. Well, I kinda disagree.... :)

      You got to have some ideas about what you want of society and economic organisation and those are fundamentally political.

      I think it's better to admit upfront a couple of relatively non-controversial themes you want your society to follow (say, maximising public/sum of private utility/ies under the constraints of fundamental rights?), move from there to slightly more controversial ones ('some' redistribution is a Pareto improvement) and admit, that, as far as macro economics goes, the lack of counter-factual experiences and the noisiness of data, means that we can make recommendations but rarely prove beyond all reasonable doubts that something is true, let alone, true at all times.

    5. Anonymous11:44 AM

      Right but my point is that it seems (at least from my untrained eye) that public use of economic analysis comes from a pre-filtered selection that reinforces an already held bias. At least more so than other (pseudo) sciences.

      A politician doesn't want to pursue a set of policies simply because its his politics but because the gods of Economics have commanded our society be run as such.

    6. Anonymous11:48 AM

      Or as an example, Rick Perry doesn't just want a flat tax because thats how he believes wealth should be distributed morally in our society but rather because it makes sense 'economically'.

      Perhaps as technology allows us to pursue economics in a more scientific fashion this will change but until then...

  3. Anonymous12:06 AM

    Wait really!! The roundup returns?! This has been foreseen. So it begins

    1. Hehe...only once or twice, I think. I'm pretty busy these days...

    2. Actually you could just follow me on Twitter, that's better than all the roundups put together!

  4. No kidding, I just thought about getting a better idea of behavioral finance early this week. Thank you for making this so much easier.

  5. Anonymous7:54 AM

    No prospect theory, or Dan Ariely? Fama's attempt to claim that various "anamolies" aren't related to behavioral finance would be an interesting reaed as well.

    I agree it is a facinating topic... too bad one would have to go through a "traditional" econ education first to get there.

    - Jeff

  6. Thank you for taking the time to compile this list of classic papers in behavioural finance, Noah Smith. I enjoyed taking a look at all of them.

    But when I looked at the references for all of the papers you listed, I noticed that none of them cited Daniel Ellsberg's seminal 1961 article in The Quarterly Journal of Economics. For those who want to read Daniel Ellsberg's article, please see the following link.

    That stated, I think if one chooses to trace the references they cited, some of the articles cited by the scholars do cite Daniel Ellsberg's work.

    But why not cite Daniel Ellsberg directly? Obviously Noah Smith, you can't speak for all of the authors of the articles, but Daniel Ellsberg's critique of the axioms of choice as posed by Bruno de Finetti, Frank P. Ramsey, and Leonard J. Savage, is a highly original contribution with plenty of substance to draw on, and not just for theoretical matters. The axioms of choice posed by these three mathematicians are actually even more basic than Rational Expectations or the Efficient Markets Hypothesis, and widely-used at an implicit level in many economic models.

    Perhaps when you finally have your behavioural finance papers published in a peer-reviewed scholarly journal, Noah Smith, you could rectify this error by citing Daniel Ellsberg's excellent 1961 article and his 1962 doctoral thesis (which was regrettably published only in 2001), Noah Smith. For those interested in getting a copy of Daniel Ellsberg's doctoral thesis, please see the following link.

  7. Anonymous11:10 AM

    As an individual investor, I would profit much from a book on this subject ... After all, we may have the option of going to cash and not having to run with the zombies.

  8. Thank you sooooooo much for this list. My PhD I'm working on is on 'behavioral microfoundations of retail credit markets' :-D

  9. I miss Shleifer & Vishny (1997) about limits of arbitrage (though the cited "Noise Trader Risk in Financial Markets", by De Long et al. (1990) would be a clear antecedent.

  10. Noah,

    I'm reluctant to bring this up for fear of sending you off track on something unlikely to help you with tenure, but maybe it could provide insight that might help, or is worth the time – Are you familiar with the work of Robert Haugen? He was at the University of California, Irvine, sadly recently deceased at only 70. He had some very interesting and very strong opinions on the market being substantially inefficient – herd behavior and feedback, money managers having serious agent-principle problems, and more. He has an intriguing little booktito, the New Finance. I talked about some of his work in a post that was in your ROUNDUP:

  11. Life Insurance Rates Wealth Copilot provide affordable Life Insurance services at the best rates.

  12. The Browns have a long way to go.  From now on I will take that into account as well.”  Brown is well remembered by Patriots fans for the 2006 AFC divisional playoff game against San Diego when, with the Patriots down 21-13, the receiver stripped Marlon McCree after he had intercepted Tom Brady.  Ebert had a career-high 75 receptions, 1,060 receiving yards, 11 receiving touchdowns, and a career-long 90-yard reception. This leads to Patriots fumble recovery by Rob Nikovich which results in a New England Patriots field goal
    Wholesale Cheap NFL Jerseys.  New England is favored by as much as 9 points. You know the Patriots held out for that extra pick.

    If not for a ridiculous string of penalties, the Chargers may have been able to come from behind and take down the Saints last week at the Superdome. Thus, bringing back Talib is critical to a team that’s weakest spot the past few years has been in the secondary.  Buffalo is bringing in Blaine Gabbert and Christian Ponder so that will help them decide who they draft.Ravens head coach John Harbaugh has really been leaning on the cornerback blitz, which is typically a rare play used by NFL defenses, even one as exotic as Baltimore's
    cheap Oakland Raiders jerseys. Is his hair falling out? Is Brady going Terry Bradshaw? Will we see a classic comb-over next season?According to a report from the Associated Press, the national Enquirer reports that Brady's car was seen outside of the Leonard Hair Transplant Associates building in Cranston, Rhode Island. Louis he obviously didn’t have to go through again here
    cheap San Francisco 49ers jerseys.One lesson learned last season in the NFL was the importance of the backup quarterback.

    2. The game could be close through the first half but the Patriots speed and pace will eventually be too much for an older Ravens defense.15.ParzychRantSports.  Do you really think the Steelers are going to lose to a team that believes the officials robbed them of Super Bowl 40 on their home turf after losing 35 to 7 to a division rival?Most oddsmakers are spotting the Seahawks 14 points.  Thanks to Welker's decision, Welker will be able to report to Patriots, training camp so he can get in shape for the 2012 NFL Season. Maybe firing the football to slot receiver Brandon Stokley will help.

    13.The star tight end will still be All-Pro Rob Gronkowski but Shiancoe will be used to attempt to deflect attention away from his record setting teammate. Adding Welker to a guy like Brandon Marshall-yikes. With Dennard on one side and Talib on the other, the Patriots made a brazen move sending Pro Bowl cornerback Devin McCourty to safety alongside Steve Gregory.Jeff Hanisch-US PRESSWIREWith Joe Flacco and the Ravens awaiting the Patriots down in Baltimore this Sunday, the "elite" quarterback debate has dominated the airwaves of Boston sports radio this week. Louis, it looks as though the ship is finally headed in the right direction for the Patriots.Defensive Tackle Philosophy 3-4 Nose Tackle The 3-4 nose tackle is the biggest player on the defense.

  13. The central concern in behavioral finance is clearing up why market participants make systematic errors. Such errors influence prices and returns, create market inefficiencies. It also investigates how other participant arbitrage such market inefficiencies.