We consider whether sentiment affects the profitability of momentum strategies. We hypothesize that news that contradicts investors’ sentiment causes cognitive dissonance, slowing the diffusion of such news. Thus, losers (winners) become underpriced under optimism (pessimism). Short-selling constraints may impede arbitraging of losers and thus strengthen momentum during optimistic periods. Supporting this notion, we empirically show that momentum profits arise only under optimism. An analysis of net order flows from small and large trades indicates that small investors are slow to sell losers during optimistic periods. Momentum-based hedge portfolios formed during optimistic periods experience long-run reversals.

Theoretical models of portfolio choice that incorporate ambiguity predict that investors’ propensity to invest in equities is reduced when ambiguity in the stock market increases. Although this hypothesis stems from the extant theoretical literature, there is no empirical work examining whether it is supported in the data. We test this hypothesis, measuring participation using equity fund flows and ambiguity with dispersion in analyst forecasts about aggregate returns. Our results confirm this hypothesis, as we show that, controlling for other factors that affect flows, increases in ambiguity are associated with outflows from equity funds. Moreover, using data from the Survey of Consumer Finances, we find that increases in ambiguity significantly reduce the likelihood that the average household invests in equities.

We investigate the link between exchange-traded funds and real investment. Cross-sectionally, higher ETF ownership is associated with an increased sensitivity of real investment to Tobin’s q and a heightened ability of stock returns to forecast future earnings. Inclusion of stocks in industry ETFs enhances investment-q sensitivity and implies greater incorporation of earnings information into prices prior to public releases. Greater nonmarket ETF ownership leads to increased (reduced) reliance of real investment on own (peers’) stock prices. Overall, the evidence is consistent with ETFs positively affecting real investment efficiency via greater flows of information.

We design an experiment to test the hypothesis that, in violation of Bayes’ rule, some people respond more forcefully to the strength of information than to its weight. We provide incentives to motivate effort, use naturally occurring information, and control for risk attitude. We find that the strength–weight bias affects expectations but that its magnitude is significantly lower than originally reported. Controls for nonlinear utility further reduce the bias. Our results suggest that incentive compatibility and controls for risk attitude considerably affect inferences on errors in expectations.

Using hand-collected data on the cultural origins of S&P 500 CEOs and their spouses, we examine whether differences in risk attitudes within marriages influence corporate risk-taking behavior. We find that CEOs with more risk averse spouses adopt relatively safer corporate policies. The effect is stronger if the CEO comes from a more collectivist culture , has been married more recently, or shares more responsibilities with their spouse. Together, these findings suggest that the cultural composition of CEOs’ households and their spouses’ risk preference affect corporate risk-taking behavior.