firms is indeed more sensitive to cash flow than the investment of other
firms.^37
9.ConclusionBehavioral finance is a young field, with its formal beginnings in the 1980s.
Much of the research we have discussed was completed in the past decade.
Where do we stand? Substantial progress has been made on numerous fronts.
Empirical Investigation of Apparently Anomalous Facts. When De Bondt
and Thaler’s (1985) paper was published, many scholars thought that the
best explanation for their findings was a programming error. Since then their
results have been replicated numerous times by authors both sympathetic
to their view and by those with alternative views. At this stage, we think
that most of the empirical facts are agreed upon by most of the profession,
although the interpretation of those facts is still in dispute. This is progress.
If we all agree that the planets do orbit the sun, we can focus on understand-
ing why.
Limits to Arbitrage. Twenty years ago, many financial economists thought
that the Efficient Markets Hypothesis had to be true because of the forces
of arbitrage. We now understand that this was a naive view, and that the
limits to arbitrage can permit substantial mispricing. It is now also under-
stood by most that the absence of a profitable investment strategy does not
imply the absence of mispricing. Prices can be very wrong without creating
profit opportunities.
Understanding Bounded Rationality. Thanks largely to the work of cog-
nitive psychologists such as Daniel Kahneman and Amos Tversky, we now
have a long list of robust empirical findings that catalog some of the ways
in which actual humans form expectations and make choices. There has
also been progress in writing down formal models of these processes, with
prospect theory being the most notable. Economists once thought that be-
havior was either rational or impossible to formalize. We now know that
models of bounded rationality are both possible and also much more accu-
rate descriptions of behavior than purely rational models.
A SURVEY OF BEHAVIORAL FINANCE 63(^37) Another paper that can be included in the managerial irrationality category is Loughran
and Ritter’s (2002) explanation for why managers issuing shares appear to leave significant
amounts of money “on the table,” as evidenced by the high average return of IPOs on their first
day of trading. The authors note that the IPOs with good first day performance are often those
IPOs in which the price has risen far above its filing range, giving the managers a sizeable
wealth gain. One explanation is therefore that since managers are already enjoying a major
windfall, they do not care too much about the fact that they could have been even wealthier.