The basic paradigm of asset pricing is in vibrant flux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models.

This paper offers a model in which asset prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade against mispricing. In equilibrium, expected returns are linearly related to both risk and mispricing measures (e.g., fundamental/price ratios). With many securities, mispricing of idiosyncratic value components diminishes but systematic mispricing does not. The theory offers untested empirical implications about volume, volatility, fundamental/price ratios, and mean returns, and is consistent with several empirical findings. These include the ability of fundamental/price ratios and market value to forecast returns, and the domination of beta by these variables in some studies.