Essays on asset pricing, portfolio choice, and investments

This dissertation studies two interrelated areas of behavioral finance. The first one deals with investors' preferences and expectations, and the second one with stock market mispricing. The essays in the dissertation study applications of these broader areas to portfolio choice, cross-sectional stock returns, expectations formation, and time-varying merger activity. The first two essays examine how investors make investment decisions given their expectations and how they form these expectations. The first essay explores a model of international portfolio choice, where correlations across international stock markets depend on the state of the economy, and investors are averse to disappointing outcomes. The results show that this combination can lead to a high optimal degree of diversification during periods of market distress, but a substantial overweight in the domestic market (i.e. home bias) in the more favorable states of the economy. The model is also able to rationalize the empirically observed phenomenon of return chasing. The second essay studies the return expectations of finance professionals in Finland and Sweden. We find that the subjects are implausibly optimistic on the relative performance of stocks over bonds. Their return and volatility expectations are not consistent with their estimates of stocks outperforming bonds. Furthermore, they are overconfident in the sense that they underestimate the risk of uncertain outcomes. The remaining two essays focus on aspects related to stock market mispricing. In the third essay, we show that the high return associated with stocks with high book-to-market ratios (the so called value effect) is at least partly driven by stock market mispricing. Furthermore, we document that hedge funds are able to identify undervalued securities and that hedge fund flows decrease the level of relative mispricing in the stock market. Equity market misvaluation is also one of the proposed causes of merger waves, i.e. periods with high merger activity. In the fourth essay we study the implications of these waves on deal characteristics. Our results show that periods of high merger activity are related to smaller markups, higher stock price run-ups, and a more frequent use of equity financin