| This dissertation consists of three essays on investor behavior. The first essay examines financial markets in which price-taking traders, a strategic-trading insider, and risk-averse market-makers are overconfident. It also analyzes the effects of overconfidence when information is costly. The effects of overconfidence depend on who in a market is overconfident and on how information is distributed. Overconfidence increases expected trading volume and market depth while lowering the expected utilities of the overconfident. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, or highly relevant information, while they overreact to salient, anecdotal, or less relevant information. The second chapter tests the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analysing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low price stocks. Nor is it justified by subsequent portfolio performance. For taxable investments it is non-optimal and leads to lower after-tax returns. Tax-motivated selling is most evident in December. The third essay shows that investors at a discount brokerage trade excessively. By analysing the same trading records as in essay two, I test whether the stocks these investors purchase outperform those they sell by enough to cover the costs of trading. I find the surprising result that, on average, the stocks they purchase actually underperform those they sell. This is the case even when trading is not apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk securities. I examine return patterns before and after transactions. Return patterns before purchases and sales can be explained by the difficulty of the search for stocks to buy, investors' tendency to let their attention be directed by outside sources, the disposition effect, and investors' reluctance to sell short. |