Investor Psychology and Asset PricingDAVID HIRSHLEIFER*ABSTRACTThe basic paradigm of asset pricing is in vibrant flux. The purely rational ap-proach is being subsumed by a broader approach based upon the psychology ofinvestors. In this approach, security expected returns are determined by both riskand misvaluation. This survey sketches a framework for understanding decisionbiases, evaluates the a priori arguments and the capital market evidence bearingon the importance of investor psychology for security prices, and reviews recentmodels.The best plan is...to profit by the folly of others.— Pliny the Elder, from John Bartlett, comp.Familiar Quotations, 9th ed. 1901.IN THE MUDDLED DAYS BEFORE THE RISE of modern finance, some otherwise-reputable economists, such as Adam Smith, Irving Fisher, John MaynardKeynes, and Harry Markowitz, thought that individual psychology affectsprices.1What if the creators of asset-pricing theory had followed this thread?Picture a school of sociologists at the University of Chicago proposing theDeficient Markets Hypothesis: that prices inaccurately reflect all availableinformation. A brilliant Stanford psychologist, call him Bill Blunte, inventsthe Deranged Anticipation and Perception Model ~or DAPM!, in which prox-ies for market misvaluation are used to predict security returns. Imaginethe euphoria when researchers discovered that these mispricing proxies ~such* Hirshleifer is from the Fisher College of Business, The Ohio State University. This surveywas written for presentation at the American Finance Association Annual Meetings in NewOrleans, January, 2001. I especially thank the editor, George Constantinides, for valuable com-ments and suggestions. I also thank Franklin Allen, the discussant, Nicholas Barberis, RobertBloomfield, Michael Brennan, Markus Brunnermeier, Joshua Coval, Kent Daniel, Ming Dong,Jack Hirshleifer, Harrison Hong, Soeren Hvidkjaer, Ravi Jagannathan, Narasimhan Jegadeesh,Andrew Karolyi, Charles Lee, Seongyeon Lim, Deborah Lucas, Rajnish Mehra, Norbert Schwarz,Jayanta Sen, Tyler Shumway, René Stulz, Avanidhar Subrahmanyam, Siew Hong Teoh, Sheri-dan Titman, Yue Wang, Ivo Welch, and participants of the Dice Finance Seminar at Ohio StateUniversity for very helpful discussions and comments.1Smith analyzed how the “overweening conceit” of mankind caused labor to be underpricedin more enterprising pursuits. Young workers do not arbitrage away pay differentials becausethey are prone to overestimate their ability to succeed. Fisher wrote a book on money illusion;in The Theory of Interest ~~1930!, pp. 493–494! he argued that nominal interest rates system-atically fail to adjust sufficiently for inflation, and explained savings behavior in relation toself-control, foresight, and habits. Keynes ~1936! famously commented on animal spirits instock markets. Markowitz ~1952! proposed that people focus on gains and losses relative toreference points, and that this helps explain the pricing of insurance and lotteries.THE JOURNAL OF FINANCE • VOL. LVI, NO. 4 • AUGUST 20011533as book0market, earnings0price, and past returns!, and mood indicators suchas amount of sunlight, turned out to be strong predictors of future returns.At this point, it would seem that the deficient markets hypothesis was thebest-confirmed theory in the social sciences.To be sure, dissatisfied practitioners would have complained that it is harderto actually make money than ivory tower theorists claim. One can even imag-ine some academic heretics documenting rapid short-term stock market re-sponses to news arrival in event studies, and arguing that security returnpredictability results from rational premia for bearing risk. Would the old guardsurrender easily? Not when they could appeal to intertemporal versions of theDAPM, in which mispricing is only corrected slowly. In such a setting, short-window event studies cannot uncover the market’s inefficient response to newinformation. More generally, given the strong theoretical underpinnings of mar-ket inefficiency, the rebels would probably have an uphill fight.This alternative history suggests that the traditional view that financialeconomists have had about the rationality of asset prices was not as inevi-table as it may seem. Despite many empirical studies, scholarly viewpointson the rationality of asset pricing have not converged. This is probably aresult of strong prior beliefs on both sides. On one side, strong priors arereflected in the methodological claim that we should adhere to rational ex-planations unless the evidence compels rejection, and in the use of the term“risk premium” interchangeably with “mean return in excess of the risk-freerate.” For those on the opposite side, risk often comes quite late in the list ofpossible explanations for return predictability.Often advocates of one approach or the other have cast the first stone outthe door of their own glass house. There is, in fact, a notable parallelismamong objections to the two approaches, illustrated in corresponding fashionin Table I. ~Lining up each objection with its counterpart does not implyparity in the validity of the arguments.!This survey assesses the theory and evidence regarding investor psychol-ogy as a determinant of asset prices. This issue is at the heart of a granddebate in finance spanning the last two decades. In the last few years, fi-nancial economists have grown more receptive to imperfect rational expla-nations. Over time I believe that the purely rational paradigm will be subsumedby a broader psychological paradigm that includes full rationality as a sig-nificant special case.Two superb recent presentations of the asset pricing field ~Campbell ~2000!and Cochrane ~2000!! emphasize objective external sources of risk. As Camp-bell puts it ~p. 1516!, “... asset pricing is concerned with the sources of riskand the economic forces that determine the rewards for bearing risk.” ForCochrane ~p. 455!, “The central task of financial economics is to figure outwhat are the real risks that drive asset prices and expected returns.”In contrast, I argue here that the central task of asset pricing is to exam-ine how expected returns are related to risk and to investor misvaluation.Campbell’s survey emphasizes the stability of the finance paradigm over thelast two decades. I will argue that the basic paradigm of asset pricing is invigorous and productive flux.1534 The Journal of FinanceFigure 1 illustrates static asset