Behavioral finance.

• Author: Stein, Jeremy C.

Much of my research over the last several years has been in the broad area of behavioral finance. Some of this work investigates the beliefs of less-than-fully rational investors--the valuation models they use, and the particular sources of information that they pay attention to. Another part focuses on the constraints that professional arbitrageurs face because of the agency problems inherent in delegated money management. Finally, a third strand explores the connection between investor irrationality and corporate-finance outcomes.

Simple Models

In attempting to make even the most basic kinds of forecasts, we can find ourselves inundated with a staggering amount of potentially relevant raw data. A large literature in psychology suggests that people simplify such forecasting problems by focusing their attention on a small subset of the available data. One powerful way to simplify is with the aid of a theoretical model. A parsimonious model will focus the user's attention on those pieces of information deemed to be particularly relevant for the forecast at hand; the user will disregard the rest. For example, an investor with an "honest-accounting" model of the world who examines a firm's annual report may focus on earnings per share, while ignoring much of the other material in, say, the footnotes.

Of course, even people who use very simple models are likely to give up on these models when they fare poorly--as the honest-accounting model is likely to have done in recent years--and to move on to alternatives. Motivated by this idea, Harrison Hong and I study the implications of learning in an environment where the true model of the world is multivariate, but in which agents update only over the class of simple univariate models. (1) If a particular simple model does a poor job of forecasting over a period of time, it is eventually discarded in favor of an alternative--yet equally simple --model that would have done better over the same period. This theory makes several distinctive predictions. For example, it suggests that a high-priced glamour stock has particularly low conditional expected returns, and particularly high conditional volatility, in the wake of recent bad news about fundamentals, because this high-price/bad-news configuration suggests that the potential for a "paradigm shift" among investors is elevated.

In a related vein, Philippe Aghion and I examine a setting in which a firm can devote its efforts either to increasing sales growth or to improving per-unit profit margins, for example by cutting costs. (2) If the firm's manager is concerned with the current stock price, she will tend to favor the growth strategy when the stock market is following a valuation model that pays more attention to performance on the growth dimension. Conversely, it can be rational for the stock market to weight observed growth measures more heavily when it is known that the firm is following a growth strategy. This two-way feedback between firms' business strategies and the market's valuation model can lead to purely intrinsic fluctuations in sales and output, creating excess volatility in these real variables even in the absence of any external source of shocks.

Local and Social Influences on Investment Decisions

A number of recent papers show that investors tend to have a strong...