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When assessing a fund manager's skill, sophisticated investors will consider all factors (priced and unpriced) that explain cross-sectional variation in fund performance. We investigate which factors investors attend to by analyzing mutual fund flows as a function of recent returns decomposed into alpha and factor-related returns. Surprisingly, investors attend most to market risk (beta) when evaluating funds and treat returns attributable to size, value, momentum, and industry factors as alpha. Using proxies for investor sophistication (wealth, distribution channels, and periods of high investor sentiment), we find that more sophisticated investors use more sophisticated benchmarks when evaluating fund performance.

A risk-averse manager's overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.

People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.

Investors' previous experiences with a stock affect their willingness to repurchase that stock. Using detailed trade data from two brokers, the authors document that investors are reluctant to repurchase stocks previously sold for a loss and stocks that have risen in price subsequent to a prior sale. The authors propose that this behavior reflects investors' emotional reactions to trading and their attempts to distance themselves from negative emotions (e.g., disappointment, regret). Investors are disappointed when they sell a stock for a loss and regret having ever purchased the stock; these negative emotions deter investors from later repurchasing stocks they sold for a loss. Having sold a stock, investors are disappointed if the stock continues to rise and regret having sold the stock in the first place; these negative emotions deter investors from repurchasing stocks that go up since being sold. Thus, investors engage in reinforcement learning by repurchasing stocks whose previous purchase resulted in positive emotions and avoiding stocks whose previous purchase resulted in negative emotions.

Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.

We argue that the purchase decisions of mutual fund investors are influenced by salient, attention‐grabbing information. Investors are more sensitive to salient, in‐your‐face fees, like front‐end loads and commissions, than operating expenses; they buy funds that attract their attention through exceptional performance, marketing, or advertising. We analyze mutual fund flows over the last 30 years and find negative relations between flows and front‐end‐load fees. In contrast, we find no relation between operating expenses and flows. Additional analyses indicate that marketing and advertising, the costs of which are often embedded in funds' operating expenses, account for this surprising result.

This paper takes a first step toward demonstrating that overall trading volume and equity markets is excessive by showing that it is excessive for a particular group of investors: those with discount brokerage accounts. These investors trade excessively in the sense that their returns are, on average, reduced through trading. The hypothesis that investors trade excessively because they are overconfident is tested. Overconfident investors may trade even when their expected gains through trading are not enough to offset trading costs. In fact, even when trading costs are ignored, these investors actually lower their returns through trading. This result is more extreme than is predicted by overconfidence alone.

I test the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. For taxable investments, it is suboptimal and leads to lower after-tax returns. Tax-motivated selling is most evident in December.

We test and confirm the hypothesis that individual investors are net buyers of attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one-day returns. Attention-driven buying results from the difficulty that investors have searching the thousands of stocks they can potentially buy. Individual investors do not face the same search problem when selling because they tend to sell only stocks they already own. We hypothesize that many investors consider purchasing only stocks that have first caught their attention. Thus, preferences determine choices after attention has determined the choice set.

Retail order imbalance positively predicts returns, but on average retail investor trades lose money. Why? Order imbalance tests equal-weighted stocks, but retail purchases concentrate on attention-grabbing stocks that subsequently underperform. Long–short strategies based on extreme quintiles of retail order imbalance earn dismal annualized returns of −14.8% among stocks with heavy retail trading but earn 6.6% among other stocks. Our results reconcile the literatures on the performance of retail investors, the predictive content of retail order imbalance, and attention-induced trading and returns. Smaller retail trades concentrate more on attention-grabbing stocks and perform worse.