In recent years there has been growing interest in the mixture of psychology and economics that has come to be known as “behavioral economics.” As is true with many seemingly overnight success stories, this one has been brewing for quite a while. My first paper on the subject was published in 1980, hot on the heels of Kahneman and Tversky’s (1979) blockbuster on prospect theory, and there were earlier forerunners, most notably Simon (1955, 1957) and Katona (1951, 1953). The rise of behavioral economics is sometimes characterized as a kind of paradigm-shifting revolution within economics, but I think that is a misreading of the history of economic thought. It would be more accurate to say that the methodology of behavioral economics returns economic thinking to the way it began, with Adam Smith, and continued through the time of Irving Fisher and John Maynard Keynes in the 1930s. In spite of this early tradition within the field, the behavioral approach to economics met with considerable resistance within the profession until relatively recently. In this essay I begin by documenting some of the historical precedents for utilizing a psychologically realistic depiction of the representative agent. I then turn to a discussion of the many arguments that have been put forward in favor of retaining the idealized model of Homo economicus even in the face of apparently contradictory evidence. I argue that such arguments have been refuted, both theoretically and empirically, including in the realm where we might expect rationality to abound: the financial markets. As such, it is time to move on to a more constructive approach. On the theory side, the basic problem is that we are relying on one theory to accomplish two rather different goals, namely to characterize optimal behavior and to predict actual behavior. We should not abandon the first type of theories as they are essential building blocks for any kind of economic analysis, but we must augment them with additional descriptive theories that are derived from data rather than axioms. As for empirical work, the behavioral approach offers the opportunity to develop better models of economic behavior by incorporating insights from other social science disciplines. To illustrate this more constructive approach, I focus on one strong

Many observers of the current economic scene are concerned about the low rate of personal saving in the United States. One well-known researcher, Laurence Kotlikoff (1992), calls the situation a crisis. He proposes that each American worker receive an annual statement from the Social Security Administration with projected benefits upon retirement, arguing that: each of us got [this statement] our attention would be caught and perhaps our of saving, which is in such urgent need of redress, would really change (p. 107). I agree with the thrust of Kotlikoff's recommendations, and join him in applauding steps that will alter the general public's of However, as economists, we need to recognize that the economic theory of saving is similarly in urgent need of redress. If we are to understand why people are saving so little and are to make helpful recommendations as to how to get people to save more, we have to incorporate more of the of saving into our economic theories. Kotlikoff's policy proposal, while a sensible one, highlights the growing gap between theory and policy prescription in this domain. If households are acting in accordance with the life-cycle theory of saving, then undersaving is impossible, so why do they need to have their psychology redressed? And, how does this psychology fit into the model? This example reflects an increasing frustration in the economics community about personal saving. Many observers have come to the conclusion that the low saving rate represents an important problem on two fronts: macroeconomists worry that the low saving rate will produce too little investment, and microeconomists worry that individuals, particularly the baby boomers, are not putting enough away to finance a satisfactory lifestyle in retirement. These are serious concerns. However, the frustration comes from the realization that, even if there was agreement that the saving rate needs to go up, economic theory offers little help in constructing a solution. In the standard life-cycle framework the only policy variable is the after-tax rate of return to saving. Yet it is well known that the theory does not specify the sign of the relationship between the saving rate and the interest rate. Raising the interest rate increases the returns to saving but decreases the amount of saving necessary to yield any given future consumption level. Furthermore, empirical estimates offer little help. Most studies are unable to reject the hypothesis that the elasticity of personal saving with respect to the interest rate is zero. Clearly this is frustrating: the theory only gives us one lever to use, and we don't know whether to push or pull! With this background, I wish to supply what should be considered good news: the theory is misspecified. Life-cycle models of saving fail to describe actual household saving in three important ways. This failure of the theory is good news because by incorporating some basic we can enrich the theory and generate specific policy recommendations. In this paper I will begin by characterizing the problems with the theory and then go on to discussing the implications of modifying the theory.

There is a worldwide trend toward defined contribution saving plans and growing interest in privatized Social Security plans. In both environments, individuals are given some responsibility to make their own asset-allocation decisions, raising concerns about how well they do at this task. This paper investigates one aspect of the task, namely diversification. We show that some investors follow the “1/n strategy”: they divide their contributions evenly across the funds offered in the plan. Consistent with this naive notion of diversification, we find that the proportion invested in stocks depends strongly on the proportion of stock funds in the plan.

Preface xi Richard H. Thaler Acknowledgments xix List of Abbreviations xxiii Chapter 1: A Survey of Behavioral Finance by Nicholas Barberis and Richard H. Thaler 1 Part I: Limits to Arbitrage Chapter 2: The Limits of Arbitrage by Andrei Shleifer and Robert W. Vishny 79 Chapter 3: How Are Stock Prices Affected by the Location of Trade? by Kenneth A. Froot and Emil M. Dabora 102 Chapter 4: Can the Market Add and Subtract? Mispricing in Tech Stock Carve-outs by Owen A. Lamont and Richard H. Thaler 130 Part II: I Stock Returns and the Equity Premium Chapter 5: Valuation Ratios and the Long-run Stock Market Outlook: An Update by John Y. Campbell and Robert J. Shiller 173 Chapter 6: Myopic Loss Aversion and the Equity Premium Puzzle by Shlomo Benartzi and Richard H. Thaler 202 Chapter 7: Prospect Theory and Asset Prices by Nicholas Barberis, Ming Huang, and Tano Santos 224 Part III: Empirical Studies of Overreaction and Underreaction Chapter 8: Contrarian Investment, Extrapolation, and Risk by Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny 273 Chapter 9: Evidence on the Characteristics of Cross-sectional Variation in Stock Returns by Kent Daniel and Sheridan Titman 317 Chapter 10: Momentum by Narasimhan Jegadeesh and Sheridan Titman 353 Chapter 11: Market Efficiency and Biases in Brokerage Recommendations by Roni Michaely and Kent L. Womack 389 Part IV: Theories of Overreaction and Underreaction Chapter 12: A Model of Investor Sentiment by Nicholas Barberis, Andrei Shleifer, and Robert W. Vishny 423 Chapter 13: Investor Psychology and Security Market Under- and Overreaction by Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam 460 Chapter 14: A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets by Harrison Hong and Jeremy C. Stein 502 Part V: Investor Behavior Chapter 15: Individual Investors by Brad M. Barber and Terrance Odean 543 Chapter 16: Naive Diversification Strategies in Defined Contribution Savings Plans by Shlomo Benartzi and Richard H. Thaler 570 Part VI: Corporate Finance Chapter 17: Rational Capital Budgeting in an Irrational World by Jeremy C. Stein 605 Chapter 18: Earnings Management to Exceed Thresholds by Francois Degeorge, Jayendu Patel, and Richard Zeckhauser 633 Chapter 19: Managerial Optimism and Corporate Finance by J. B. Heaton 667 List of Contributors 685 Index 695

As firms switch from defined-benefit plans to defined-contribution plans, employees bear more responsibility for making decisions about how much to save. The employees who fail to join the plan or who participate at a very low level appear to be saving at less than the predicted life cycle savings rates. Behavioral explanations for this be-havior stress bounded rationality and self-control and suggest that at least some of the low-saving households are making a mistake and would welcome aid in making decisions about their saving. In this paper, we propose such a prescriptive savings program, called Save More Tomorrow (hereafter, the SMarT program). The essence of the program is straightforward: people commit in advance to allocat-ing a portion of their future salary increases toward retirement savings. We report evidence on the first three implementations of the SMarT program. Our key findings, from the first implementation, which has We are grateful to Brian Tarbox for implementing the Save More Tomorrow plan and for sharing the data with us. We would also like to thank many people at the following