TABLE OF CONTENTS Traditional asset pricing theory and behavioral asset pricing theory share a common framework. The stochastic discount factor (SDF) constitutes the core concept in both approaches. The features that distinguish the two approaches are the differing assumptions and results.
Traditional asset pricing theory assumes that prices are set as if investors hold correct beliefs about the underlying stochastic process governing returns, and have preferences that conform to expected utility theory. In contrast, behavioral asset pricing theory assumes that investors are subject to systematic psychologically induced errors, and have preferences that violate the assumptions of expected utility theory.
The behavioral decision literature identifies a rich set of systematic errors to which people are vulnerable. Of these, the most important for asset pricing theory is representativeness. Chapters 6 and 7 present empirical evidence relating to the impact of representativeness on investors. Representativeness induces naive individual investors to succumb to extrapolation bias, and predict unwarranted continuation. Representativeness induces experienced professional investors to succumb to gambler s fallacy, and predict unwarranted reversals. Overconfidence amplifies representativeness-based errors, and also induces investors to underestimate risk.
A common finding in behavioral studies is that people are heterogeneous. People hold different beliefs, differ in their tolerance for risk, and differ in their levels of patience. These differences can be important and affect both prices and trading volume. Individual differences are typically large.
Representativeness causes heterogeneity to have a time varying structure. The extent to which investors disagree has a predictable...
