trading needs of their employees. Neither of these studies can prove that the
Internet causes increased trading, but they do provide preliminary evidence.
The theme of control is pervasive in the advertising of financial e-
commerce firms. One Ameritrade advertisement, for example, states that
online investing “is about control.” Balasubramanian, Konana, and Menon
(1999) list “feeling of empowerment” as one of seven basic reasons given
for switching to online trading by visitors to an online brokerage house’s
website. Psychologists find that people behave as if their personal involve-
ment can influence the outcome of chance events—an effect labeled the
illusion of control (Langer 1977, Langer and Roth 1975, for a review, see
Presson and Benassi 1996). This literature documents that overconfi-
denceoccurs when factors ordinarily associated with improved perfor-
mance in skilled situations—such as choice, task familiarity, competition,
and active involvement—are present in situations at least partly governed
by chance. The problem is that investors are likely to confuse the control
they have—over which investments they make, with the control that they
lack, over the return those investments realize. As a result, they are likely to
trade too often and too speculatively.
5.ConclusionOne of the major contributions of behavioral finance is that it provides in-
sights into investor behavior where such behavior cannot be understood
using traditional theories. In this chapter we review tests of two behavioral
finance theories—the disposition effect, which emanates from Kahneman
and Tversky’s Prospect Theory, and overconfidence. Consistent with the
predictions of prospect theory, there is compelling evidence that investors
tend to sell their winning investments and to hold onto their losers. As a re-
sult of overconfidence, investors trade too much. These behaviors reduce
investor welfare. Understanding these behaviors is therefore important for
investors and for those who advise them.
But the welfare consequences of investor behavior extend beyond indi-
vidual investors and their advisors. Modern financial markets depend on
trading volume for their very existence. It is trading—commissions and
spreads—that pays for the brokers and market-makers without whom
these markets would not exist. Traditional models of financial markets give
us very little insight into why people trade as much as they do. In some mod-
els, investors seldom trade or do not trade at all (e.g., Grossman 1976). Other
models simply stipulate a class of investors—noise or liquidity traders—who
are required to trade (e.g., Kyle 1985). Harris and Raviv (1993) and Varian
(1989) point out that heterogeneous beliefs are needed to generate signifi-
cant trading. But it is behavioral finance that gives us insights into why and
when investors form heterogeneous beliefs.
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