We study asset prices in an economy where some investors categorize risky assets into different styles and move funds among these styles depending on their relative performance. In our economy, assets in the same style comove too much, assets in different styles comove too little, and reclassifying an asset into a new style raises its correlation with that style. We also predict that style returns exhibit a rich pattern of own- and cross-autocorrelations and that while asset-level momentum and value strategies are profitable, their style-level counterparts are even more so. We use the model to shed light on several style-related empirical anomalies.

A number of authors have suggested that investors derive utility from realizing gains and losses on assets that they own. We present a model of this “realization utility,” analyze its predictions, and show that it can shed light on a number of puzzling facts. These include the disposition effect, the poor trading performance of individual investors, the higher volume of trade in rising markets, the effect of historical highs on the propensity to sell, the individual investor preference for volatile stocks, the low average return of volatile stocks, and the heavy trading associated with highly valued assets.

Building on Vijh (Rev. Financial Stud. 7 (1994)), we use additions to the S&P 500 to distinguish two views of return comovement: the traditional view, which attributes it to comovement in news about fundamental value, and an alternative view, in which frictions or sentiment delink it from fundamentals. After inclusion, a stock's beta with the S&P goes up. In bivariate regressions which control for the return of non-S&P stocks, the increase in S&P beta is even larger. These results are generally stronger in more recent data. Our findings cannot easily be explained by the fundamentals-based view and provide new evidence in support of the alternative friction- or sentiment-based view.

Recent empirical research in finance has uncovered two families of pervasive regularities: underreaction of stock prices to news such as earnings announcements, and overreaction of stock prices to a series of good or bad news. In this paper, we present a parsimonious model of investor sentiment, or of how investors form beliefs, which is consistent with the empirical findings. The model is based on psychological evidence and produces both underreaction and overreaction for a wide range of parameter values.

We present an extrapolative model of bubbles. In the model, many investors form their demand for a risky asset by weighing two signals—an average of the asset’s past price changes and the asset’s degree of overvaluation—and “waver” over time in the relative weight they put on them. The model predicts that good news about fundamentals can trigger large price bubbles, that bubbles will be accompanied by high trading volume, and that volume increases with past asset returns. We present empirical evidence that bears on some of the model’s distinctive predictions.

Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns; importantly, however, it is also consistent with the survey evidence on investor expectations.