BPHD Behavioral Finance Syllabus for Fall :30 a.m. 3:15 p.m. M Friday 207

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1 Instructor: Office hours: BPHD Behavioral Finance Syllabus for Fall :30 a.m. 3:15 p.m. M Friday 207 Dmitry Shapiro 219C Friday Building Phone: dashapir@uncc.edu Web: 11:00-12:30 and 3:30-5:00 M, or by appointment. Course Description: Much of modern financial economics works with models in which agents are rational and arbitrageurs can fix any mis-pricing. Behavioral Financial Economics is the area of finance which relaxes both of these assumptions. Behavioral models usually have two building blocks: limits to arbitrage, which make it difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. We discuss these two topics, and then consider a number of applications such as asset pricing (the aggregate stock market and the cross-section of average returns) or individual investor portfolio choice and trading behavior. Prerequisites: For master students the prerequisites are Master level Microeconomics and Finance classes. Students who took only one class can take this course but perhaps should discuss it with me first. Objectives: The objective of this course is to introduce students to the field of behavioral financial economics. Upon completion of the course students should be familiar with the main concepts and a recent research in the area. Requirements and Grading: The grade will be based on class participation and presentations. In addition to that there will be the final exam in the end of the class. Course Text: There is no required text for this course. You are mostly expected to read papers. Recommended books are: Strongly recommended: Shleifer, Andrei (2000), Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press. Thaler, Richard (ed.), (2005), Advances in Behavioral Finance II, Princeton University Press. Optional: Shefrin, Hersh (1999), Beyond Fear and Greed, Harvard Business School Press. Shiller, Robert (2005), Irrational Exuberance, 2nd edition, Princeton University Press. 1

2 SURVEY PAPERS Required: Barberis, Nicholas, and Richard Thaler (2003), A Survey of Behavioral Finance, in George Constantinides, Milton Harris, Rene Stulz (eds.), Handbook of the Economics of Finance, North Holland. Rubinstein, Mark (2001), Rational Markets: Yes or No? The Affirmative Case, Financial Analysts Journal (May-June), Optional: Hirshleifer, David (2001), Investor Psychology and Asset Pricing, Journal of Finance 56, A Tentative Course and Further Reading RESEARCH ARTICLES Starred articles are required. You will occasionally see suggestions on where to track down hard-to-find articles. Several of the articles are in Inefficient Markets or in one of the two Advances books. The non-starred readings are optional. Even though they are optional, you will learn something from all of them, so take a look at as many of them as you can. References to a Survey in the reading list refer to the survey by Nick Barberis with Richard Thaler, listed above. 1. INTRODUCTION * Inefficient Markets, Chapter LIMITS TO ARBITRAGE. Theory * Survey, pages 2-8. * Inefficient Markets, Chapters 2, 4. Abreu, Dilip and Markus Brunnermeier (2002), Synchronization Risk and Delayed Arbitrage, Journal of Financial Economics 66, DeLong, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert Waldmann, Noise Trader Risk in Financial Markets, Journal of Political Economy 98, [in Advances, Chapter 2; also covered, in slightly revised form, in Inefficient Markets, Chapter 2.] * Fama, Eugene, and Kenneth French, Disagreement, Tastes, and Asset Prices, Working paper, Dartmouth University. Shleifer, Andrei, and Robert Vishny (1997), The Limits of Arbitrage, Journal of Finance 52, [also covered, in shortened form, in Inefficient Markets, Chapter 4] Yan, Hongjun (2004), Natural Selection in Financial Markets: Does it Work? Working paper, Yale University. 2

3 3. LIMITS TO ARBITRAGE. Evidence * Survey, pages * Brunnermeier, Markus, and Stefan Nagel (2004), Hedge Funds and the Technology Bubble, Journal of Finance 59, Danis, McConnell, Ovtchinnikov and Yu (2003) S&P 500 Index Additions and Earnings Expectations, Journal of Finance, v. 58, No 5, pp Froot, Kenneth and Emil Dabora (1999) How are stock prices affected by the location of trade?, Journal of Financial Economics, v. 53, pp Lamont, Owen, and Richard Thaler (2003), Anomalies: the Law of One Price in Financial Markets, Journal of Economic Perspectives, Fall * Lamont, Owen, and Richard Thaler (2003), Can the Market Add and Subtract? Mispricing in Tech Stock Carve-Outs, Journal of Political Economy 111, * Mitchell, Mark, Todd Pulvino, and Erik Stafford (2002), Limited Arbitrage in Equity Markets, Journal of Finance 57, Shleifer, Andrei (1986), Do Demand Curves for Stocks Slope Down? Journal of Finance 41, Wurgler, Jeffrey, and Katya Zhuravskaya (2002), Does Arbitrage Flatten Demand Curves for Stocks? Journal of Business 75, PSYCHOLOGY: PREFERENCES AND BELIEFS Books Gilovich, Tom, David Griffin and Daniel Kahneman (eds.), (2002), Heuristics and Biases: The Psychology of Intuitive Judgment, Cambridge: Cambridge University Press [a collection of recent articles on beliefs ] Kahneman, Daniel, Paul Slovic and Amos Tversky (eds.), (1982), Judgment Under Uncertainty: Heuristics and Biases, Cambridge: Cambridge University Press [a collection of older articles on beliefs ] Kahneman, Daniel, and Amos Tversky (eds.), (2000), Choices, Values and Frames, Cambridge: Cambridge University Press [a collection of recent articles on preferences ] * Survey, pages Survey Papers Camerer, Colin (1995), Individual Decision Making, in John Kagel and Alvin Roth (eds.), Handbook of Experimental Economics, Princeton University Press. Kahneman, Daniel, and Mark Riepe (1998), Aspects of Investor Psychology, Journal of Portfolio Management 24,

4 * Rabin, Matthew (1998), Psychology and Economics, Journal of Economic Literature, Thaler, Richard (1999), Mental Accounting Matters, Journal of Behavioral Decision Making 12, Research articles Brunnermeier, Markus and Jonathan Parker (2005), Optimal Expectations, American Economic Review, forthcoming. * Kahneman, Daniel, and Amos Tversky (1974), Judgment Under Uncertainty: Heuristics and Biases, Science 185, * Kahneman, Daniel, and Amos Tversky (1979), Prospect Theory: An Analysis of Decision Under Risk, Econometrica 47, Mullainathan, Sendhil (2001), Thinking Through Categories, Working paper, Harvard University. * Rabin, Matthew (2000), Risk Aversion and Expected Utility, Econometrica 68, Rabin, Matthew, and Richard Thaler (2001), Risk Aversion, Journal of Economic Perspectives 15, APPLICATIONS. INDIVIDUAL INVESTOR BEHAVIOR * Survey, pages * Barber, Brad, and Terrance Odean (2000), Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, Journal of Finance 55, Barber, Brad, and Terrance Odean (2002), Online Investors: Do the Slow Die First? Review of Financial Studies 15, * Barber, Brad, and Terrance Odean (2001), All that Glitters: the Effect of Attention on the Buying Behavior of Individual and Institutional Investors, Working paper, UC Berkeley. Barber, Brad, and Terrance Odean (2009) Just how much do individual investors lose by trading?, Review of Financial Studies, v. 22 (2), pp Barberis, Nicholas, and Wei Xiong (2009) What Drives the Disposition Effect? An Analysis of a Long-standing Preference-based Explanation, Journal of Finance, v. 64, pp Barberis, Nicholas, and Ming Huang (2009), Preferences with Frames: A New Utility Specification that Allows for the Framing of Risks, Journal of Economic Dynamics and Control 33, , August * Barberis, Nicholas, Ming Huang and Richard Thaler (2003), Individual Preferences, Monetary Gambles and Stock Market Participation, Working paper, Yale University. * Benartzi, Shlomo, and Richard Thaler (2001), Naïve Diversification Strategies in Defined Contribution Savings Plans, American Economic Review 91,

5 * Benartzi, Shlomo, and Richard Thaler (1995), Myopic Loss Aversion and the Equity Premium Puzzle, Quarterly Journal of Economics, Vol. 110, No.1 (Feb 1995), pp Bhattacharya, Holden and Jacobsen Penny Wise, Dollar Foolish: The Left-Digit Effect in Security Trading, working paper, 2010 Boehmer and Kelley Institutional Investors and the Informational Efficiency of Prices, Review of Financial Studies, v. 22(9), pp * Cohen, Lauren (2004), Loyalty-based Portfolio Choice, Working paper, Yale University. Coval, Joshua, and Tyler Shumway (2005), Do Behavioral Biases Affect Prices? Journal of Finance, forthcoming. Epstein Larry and Martin Schneider Learning Under Ambiguity, Working paper, * Genesove, David, and Christopher Mayer (2001), Loss Aversion and Seller Behavior: Evidence from the Housing Market, Quarterly Journal of Economics 116, Glaser Markus and Martin Weber (2007) Overconfidence and Trading Volume, The GENEVA Risk and Insurance Review, Vol. 32, No. 1, pp Goetzmann, William and Alok Kumar (2004), Why do Individual Investors Hold Under-diversified Portfolios? Working paper, Notre Dame University. * Grinblatt, Mark, and Matti Keloharju (2001), What Makes Investors Trade? Journal of Finance 56, * Grinblatt, Mark, and Matti Keloharju (2001), Distance, Language, and Culture Bias: The Role of Investor Sophistication, Journal of Finance 56, Graham, John, Hai Huang and Campbell Harvey (2005), Investor Competence, Trading Frequency and Home Bias, Working paper, Duke University. Heaton J, D. Lucas Portfolio Choice in the Presence of Background Risks, The Economic Journal, vol. 110 (460), pp Hirshleifer, David, Self-Enhancing Transmission Bias and Active Investing, working paper, 2009 Huberman, Gur, Familiarity Breeds Investment, Review of Financial Studies 14, * Huberman, Gur, and Wei Jiang (2005), Offering vs. Choice by 401(k) Plan Participants: Equity Exposure and Number of Funds, Journal of Finance, forthcoming. Ivkovich Zoran, James Poterba, Scott Weisbenner (2005) Tax-Motivated Trading by Individual Investors, AER, Vol. 85 (5), pp Kilka M, M Weber (2000) Home Bias in International Stock Return Expectations, Journal of Psychology and Financial Markets, Vol. 1, No. 3& 4, pp

6 Kumar, Alok, and Sonya Lim (2004), One Trade at a Time: Narrow Framing and Stock Investment Decisions of Individual Investors, Working paper, Notre Dame University. Kumar Who Gambles in the Stock Market?, Journal of Finance, v. 64(4), pp Mankiw, Gregory and Stephen P. Zeldes The consumption of stockholders and nonstockholders, Journal of Financial Economics, vol. 29, No 1, pp Mitton Todd and Keith Vorkink (2007) Equilibrium Underdiversification and the Preference for Skewness, Review of Financial Studies, 20, July, 2007, * Odean, Terrance (1998), Are Investors Reluctant to Realize their Losses? Journal of Finance 53, Odean, Terrance (1998), Do Investors Trade Too Much? American Economic Review 89, * Polkovnichenko, Valery (2004), Household Portfolio Diversification: A Case for Rank-dependent Preferences, Review of Financial Studies, Volume 18, Number 4, pp Strong N, X Xu (2003) Understanding the Equity Home Bias: Evidence from Survey Data, Review of Economics and Statistics, May 2003, 85(2): APPLICATIONS. ASSET PRICING: THE AGGREGATE STOCK MAR- KET * Survey, pages Facts and Rational Approaches Ang, Andrew, Robert Hodrick, Yuhang Xing and Xiaoyan Zhang (2009) High idiosyncratic volatility and low returns: International and further U.S. evidence, Journal of Financial Economics, v. 91, issue 1, pp Campbell, John Y. (1998), Asset Prices, Consumption, and the Business Cycle, in Taylor and Woodford (eds.) Handbook of Macroeconomics, North-Holland. * Campbell, John Y. and Robert J. Shiller (Winter 1998), Valuation Ratios and the Long-Run Stock Market Outlook, Journal of Portfolio Management. Cochrane, John, Where is the Market Going? Uncertain Facts and Novel Theories, Economic Perspectives, Federal Reserve Bank of Chicago, November/December Fama, Eugene F. and Kenneth R. French (1988), Dividend Yields and Expected Stock Returns, Journal of Financial Economics 22, Mehra, Rajnish and Edward Prescott (1985), The Equity Premium: A Puzzle, Journal of Monetary Economics 15,

7 * Shiller, Robert (1981), Do Stock Prices Move too Much to be Justified by Subsequent Changes in Dividends?, American Economic Review 71, [in Advances, Chapter 4] Behavioral Approaches (equity premium puzzle) * Barberis, Nicholas, Ming Huang, and Tano Santos (2001), Prospect Theory and Asset Prices, Quarterly Journal of Economics 116, * Barberis, Nicholas, and Ming Huang (2004), The Loss Aversion / Narrow Framing Approach to the Equity Premium Puzzle, forthcoming in Rajnish Mehra (ed.), Handbook of Investments: The Equity Premium. * Benartzi, Shlomo, and Richard Thaler (1995), Myopic Loss Aversion and the Equity Premium Puzzle, Quarterly Journal of Economics 110, Gneezy, Uri, and Jan Potters (1997), An Experiment on Risk Taking and Evaluation Periods, Quarterly Journal of Economics 112, Maenhout, Pascal (2004), Robust Portfolio Rules and Asset Pricing, Review of Financial Studies 17, Thaler, Richard, Amos Tversky, Daniel Kahneman, and Alan Schwartz (1997), The Effect of Myopia and Loss Aversion on Risk-Taking: An Experimental Test, Quarterly Journal of Economics 112, Behavioral Approaches (volatility puzzle) Modigliani, Franco and Richard Cohn (1974), Inflation and the Stock Market, Financial Analysts Journal 35, * Thaler, Richard, and Eric Johnson (1985), Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice, Management Science 36, ASSET PRICING: THE CROSS-SECTION OF AVERAGE RETURNS * Survey, pages Facts Banz, Rolf (1981), The Relation between Return and Market Value of Common Stocks, Journal of Financial Economics 9, Berk, Jonathan and Richard Stanton (2007) Managerial Ability, Compensation and the Closed-End Fund Discount Journal of Finance, v. 62(2), pp * Bernard, Victor (1992), Stock Price Reactions to Earnings Announcements, in Richard Thaler (ed.), Advances in Behavioral Finance, Chapter 11. Chen, Hsiu-Lang and Russ Wermers Style Migration and the Cross- Section of Stock Returns, working paper,

8 Chopra, Navin, Josef Lakonishok, and Jay Ritter (1992), Measuring Abnormal Performance: Do stocks overreact? Journal of Financial Economics 31, [in Advances, Chapter 10]. * Cochrane, John, New Facts in Finance, Economic Perspectives, Federal Reserve Bank of Chicago, Third Quarter 1999 [available on Cochrane s Chicago GSB web site] Cremers, Martijn, and Ankur Pareek Institutional Investors Investment Durations and Stock Return Anomalies: Momentum, Reversal, Accruals, Share Issuance and R&D Increases, working paper, * De Bondt, Werner, and Richard Thaler (1985), Does the Stock Market Overreact? Journal of Finance 40, [in Advances, Chapter 9]. Fama, Eugene (1991), Efficient Capital Markets: II, Journal of Finance 46, Fama, Eugene F. and Kenneth R. French (1992), The Cross-Section of Expected Stock Returns, Journal of Finance 47, Ikenberry, David, Josef Lakonishok, and Theo Vermaelen (1995), Market Underreaction to Open Market Share Repurchases, Journal of Financial Economics 39, * Jegadeesh, Narasimhan and Sheridan Titman (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, Journal of Finance 48, * Lakonishok, Josef, Andrei Shleifer, and Robert W. Vishny (1994), Contrarian Investment, Extrapolation, and Risk, Journal of Finance 49, La Porta, Rafael, Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny (1994), Good News for Value Stocks: Further Evidence on Market Efficiency, Journal of Finance 49, * Frazzini, Andrea, and Owen Lamont (2008), Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns, Journal of Financial Economics, v. 88 (2), pp * Loughran, Tim, and Jay Ritter (1995), The New Issues Puzzle, Journal of Finance 50, * Schultz, Paul Pseudo Market Timing and the Long-Run Performance of IPOs, Journal of Finance, 58, April Michaely, Roni, Richard Thaler, and Kent Womack (1995), Price Reactions to Dividend Initiations and Omissions, Journal of Finance 50, Rational Approaches * Daniel, Kent and Sheridan Titman (1997), Evidence on the Characteristics of Cross-Sectional Variation in Stock Returns, Journal of Finance 52, Fama, Eugene F. and Kenneth R. French (1993), Common Risk Factors in the Returns of Bonds and Stocks, Journal of Financial Economics 33,

9 Fama, Eugene F. and Kenneth R. French (1996), Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance 51, * Inefficient Markets, Chapter 6. Behavioral Approaches (Beliefs) * Barberis, Nicholas, Andrei Shleifer, and Robert Vishny (1998), A Model of Investor Sentiment, Journal of Financial Economics 49, [covered in slightly edited form in Inefficient Markets, Chapter 5]. * Daniel, Kent, David Hirshleifer, and Avanidhar Subrahmanyam (1998), Investor Psychology and Security Market Under- and Overreactions, Journal of Finance 53, Daniel, Kent, David Hirshleifer, and Avanidhar Subrahmanyam (2001), Covariance Risk, Mispricing, and the Cross-section of Security Returns, Journal of Finance 56, De Long, Brad, Andrei Shleifer, Lawrence Summers, Michael Waldmann (1990), Positive Feedback Investment Strategies and Destabilizing Rational Speculation, Journal of Finance 45, [covered in Inefficient Markets, Chapter 6]. * Fama, Eugene F. (1998), Market Efficiency, Long-Term Returns, and Behavioral Finance, Journal of Financial Economics 49, * Hong, Harrison, and Jeremy Stein (1999), A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets, Journal of Finance 54, * Hong, Harrison, Terence Lim, and Jeremy Stein (2000), Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies, Journal of Finance 55, Behavioral Approaches (Beliefs + Institutional Frictions) D Avolio, Gene (2002), The Market for Borrowing Stock, Journal of Financial Economics 66, * Chen, Joseph, Harrison Hong, and Jeremy Stein (2002), Breadth of Ownership and Stock Returns, Journal of Financial Economics 66, * Karl Diether, Christopher Malloy, and Anna Scherbina (2002), Stock Prices and Differences of Opinion: Empirical Evidence that Stock Prices Reflect Optimism, Journal of Finance 57, * Jones, Charles, and Owen Lamont (2001), Short Sale Constraints and Stock Returns, Journal of Financial Economics 66, Miller, Edward (1977), Risk, Uncertainty and Divergence of Opinion, Journal of Finance 32, Ofek, Eli, and Matthew Richardson, Dot-com Mania: Market Inefficiency in the Internet Sector, Journal of Finance 58, * Scheinkman, Jose, and Wei Xiong (2003), Overconfidence and Speculative Bubbles, Journal of Political Economy 111,

10 Behavioral Approaches (Preferences) Barberis, Nicholas, and Ming Huang (2001), Mental Accounting, Loss Aversion, and Individual Stock Returns, Journal of Finance 56, * Barberis, Nicholas, and Ming Huang (2008), Stocks as Lotteries: The Implications of Probability Weighting for Security Prices, American Economic Review 98, pp , December * Frazzini, Andrea (2005), The Disposition Effect and Under-reaction to News, Journal of Finance, forthcoming. * Grinblatt, Mark and Bin Han (2005), Prospect Theory, Mental Accounting and Momentum, Journal of Financial Economics, forthcoming. 8. BEHAVIORAL CORPORATE FINANCE * Baker, Malcolm, Richard Ruback and Jeffrey Wurgler (2004) A Survey of Behavioral Corporate Finance, survey, * Baker, Malcolm, Richard Ruback and Jeffrey Wurgler (2003) When does the Market Matter? Stock Prices and the Investment of Equity- Dependent Firms, Quarterly Journal of Economics, v. 118 (3), pp * Baker, Malcolm and Jeffrey Wurgler (2000) The Equity Share in New Issues and Aggregate Stock Returns Journal of Finance, v. 55 (5), pp * Baker, Malcolm and Jeffrey Wurgler (2002) Market Timing and Capital Structure, Journal of Finance, v. 57 (1), pp Baker, Malcolm and Jeffrey Wurgler (2004) A Catering Theory of Dividends, Journal of Finance, v. 59(3), pp Blanchard, Oliver, Charless Rhee and Lawrence Summers (1993) The Stock Market, Profit and Investment, Quarterly Journal of Economics, 108, Dong, Ming, David Hirshleifer, Scott Richardson and Siew Hong Teoh (2006) Does Investor Misvaluation Drive the Takeover Market?, Journal of Finance, v. 61(2), pp Graham, Harvey and Puri (2010) A Corporate Beauty Contest, working paper, * Jenter, Dirk (2005) Market Timing and Managerial Portfolio Decisions, Journal of Finance, v. 60(4), pp * Malmendier, Ulrike, and Geoffrey Tate (2008) Who Makes Acquisitions? CEO Overconfidence and the Market s Reaction, Journal of Financial Economics, v. 88(2), pp Malmendier, Ulrike, Geoffrey Tate and Jon Yan (2011) Overconfidence and Early-life Experiences: The Effect of Managerial Traits on Corporate Financial Policies Journal of Finance, forthcoming. 10

11 Michel, Jean-Sebastien (2010) Does Managerial Optimism Lead to a Long-Run Underperformance? Evidence from Venture Capital- Backed IPOs, working paper, Morck, Randall, Andrei Shleifer, Robert Vishny and Matthew Shapiro (1990), The Stock Market and Investment: Is the Market a Sideshow?, Brookings Paper on Economic Activity, pp Polk, Christopher and Paola Sapienza (2004) The Real Effects of Investor Sentiment, NBER working paper, Shefin, H., and M. Statman (1984) Explaining Investor Preference for Cash Dividends, Journal of Financial Economics, 13, pp * Shleifer, Andrei and Robert Vishny (2003) Stock Market Driven Acquisitions Journal of Financial Economics, v. 70, pp Stein, Jeremy (1996) Rational Capital Budgeting in an Irrational World, Journal of Business, v. 69, pp