Misvaluation and Behavioral Bias in Financial Markets

Early models in finance posit that security prices respond quickly to new information and accurately reflect their fundamental values. More recent work indicates that market frictions and the psychological limitations of traders can cause asset prices to deviate from their fundamental values for a considerable length of time. In this paper, we develop an empirical method that tests for and estimates the degree of valuation bias. Being better able to detect valuation bias reveals profit opportunities and may improve the efficiency of financial markets if it sufficiently changes trader behavior.