Investor Psychology in Capital Markets: Evidence and Policy Implications

Kent Daniel, David Hirshleifer, and Siew Hong Teoh

Journal of Monetary Economics, January 2002


We review extensive evidence about how psychological biases affect investor behavior and
prices. Systematic mispricing probably causes substantial resource misallocation. We argue
that limited attention and overconfidence cause investor credulity about the strategic
incentives of informed market participants. However, individuals as political participants
remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially, government should avoid actions that exacerbate investor biases.

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