Behavioral Bias, Valuation, and Active Management

We examine the consequences of behavioral biases in the context of valuation theory. Although the biases we consider have been well documented elsewhere, the framework we provide is new. It not only allows a rationalization of previous findings, but it also makes possible identification of the types of stocks for which specific biases will be strongest. We provide empirical evidence concerning the ability of an array of commonly used active investment strategies, such as value and growth tilts, to exploit biases. We also use the framework to test the relative importance of prospect theory and the overconfidence hypothesis as justification for momentum investing.