BARBERIS AND THALER
This review essay evaluates recent work in this rapidly growing field. In section 2, we consider the classic objection to behavioral finance, namely that even if some agents in the economy are less than fully rational, rational agents will prevent them from influencing security prices for very long, through a process known as arbitrage. One of the biggest successes of be- havioral finance is a series of theoretical papers showing that in an econ- omy where rational and irrational traders interact, irrationality can have a substantial and long-lived impact on prices. These papers, known as the lit- erature on “limits to arbitrage,” form one of the two buildings blocks of behavioral finance.
To make sharp predictions, behavioral models often need to specify the form of agents’ irrationality. How exactly do people misapply Bayes’s law or deviate from SEU? For guidance on this, behavioral economists typi- cally turn to the extensive experimental evidence compiled by cognitive psychologists on the biases that arise when people form beliefs, and on people’s preferences, or on how they make decisions, given their beliefs. Psychology is therefore the second building block of behavioral finance, and we review the psychology most relevant for financial economists in section 3.2
In sections 4–8, we consider specific applications of behavioral finance: to understanding the aggregate stock market, the cross-section of average returns, and the pricing of closed-end funds in sections 4, 5 and 6 respec- tively; to understanding how particular groups of investors choose their portfolios and trade over time in section 7; and to understanding the fi- nancing and investment decisions of firms in section 8. Section 9 takes stock and suggests directions for future research.3
Behavioral finance departs from REE by relaxing the assumption of individual rational- ity. An alternative departure is to retain individual rationality but to relax the consistent beliefs assumption: while investors apply Bayes’s law correctly, they lack the information required to know the actual distribution variables are drawn from. This line of research is sometimes referred to as the literature on bounded rationality, or on structural uncertainty. For example, a model in which investors do not know the growth rate of an asset’s cash flows but learn it as best as they can from available data, would fall into this class. Although the literature we discuss also uses the term bounded rationality, the approach is quite different.
The idea, now widely adopted, that behavioral finance rests on the two pillars of limits to arbitrage and investor psychology is originally due to Shleifer and Summers (1990). 2
We draw readers’ attention to two other recent surveys of behavioral finance. Shleifer (2000) provides a particularly detailed discussion of the theoretical and empirical work on limits to arbitrage, which we summarize in section 2. Hirshleifer’s (2001) survey is closer to ours in terms of material covered, although we devote less space to asset pricing, and more to corporate finance and individual investor behavior. We also organize the material somewhat differently. 3