Advances in Behavioral Finance
Edited volume.
Summary
Thaler edited this collection of the foundational papers in behavioural finance, bringing together work published across journals during the 1980s and early 1990s that documented asset pricing behaviour inconsistent with the standard model.
The papers cover the anomalies that defined the field. Shiller's variance bounds work showed that stock prices move far more than the subsequent realised dividends justify, which contradicts the present value model. De Bondt and Thaler's overreaction papers showed that portfolios of prior losers subsequently outperform prior winners, consistent with investors extrapolating past performance too far. The closed-end fund puzzle documented persistent discounts and premiums to net asset value that no risk-based explanation accounts for, and showed the discounts co-move in ways suggesting sentiment. Papers on the equity premium puzzle showed that the historical excess return of equities over bonds is too large to be explained by plausible risk aversion. Others cover calendar effects, the small firm effect, and dividend behaviour.
The collection also includes theoretical work on the limits of arbitrage, which is the field's essential response to the objection that rational traders would eliminate any mispricing. The argument is that arbitrage is risky and costly, that arbitrageurs manage other people's money and face redemption when positions move against them, and that mispricings can therefore persist and widen.
These are technical journal papers rather than expository writing. The field has developed substantially since 1993, and several of the anomalies documented here have weakened or disappeared in subsequent data. Thaler edited a second volume in 2005, also in this reference, covering the later work.
Key takeaways 7
- Stock prices move far more than subsequent realised dividends justify, which contradicts the present value model.
- Portfolios of prior losing stocks subsequently outperform prior winners, consistent with investors extrapolating past performance.
- Closed-end fund discounts persist and co-move across funds in ways that no risk-based explanation accounts for.
- The historical equity premium is too large to be explained by any plausible degree of risk aversion.
- Arbitrage is risky and costly, so mispricings can persist and widen rather than being eliminated by rational traders.
- Arbitrageurs managing other people's money face redemptions when positions move against them, which limits how long they can hold.
- Documenting an anomaly does not establish that it can be traded, since transaction costs and capacity constrain what is exploitable.
Who should read it
Researchers and quantitatively trained investors who want the primary papers that established behavioural finance as a field.
About Richard H. Thaler
Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics, University of Chicago Booth School of Business; co-founder, Fuller & Thaler Asset Management; Nobel laureate in economics 2017
The Anomalies series and Nudge are the primary sources for behavioral economics as an applied discipline in finance and public policy.
University of Chicago Booth School of Business, Fuller & Thaler Asset Management
Similar books 6
Chosen by shared topics, the entries that hold them, and the people who recommended both.
Edited volume.
How behavioural economics was built against economists who assumed rational agents.
“He opens his new book, Misbehaving, with Vilfredo Pareto's assertion” — Howard Marks
Source: Oaktree memo 'On the Couch'
Recommended by: Howard Marks, Peter Mallouk, Tyler Cowen
Behavioural finance for practitioners: mental shortcuts, framing and market errors.
Neuroscience of investing decisions, written by Graham's modern editor.
Recommended by: Mohnish Pabrai
Classifies investors into behavioural types for advice and design.
Applies behavioural finance to building portfolios for real clients.
Where it sits in the reference 2
Topics