This thesis investigates whether or not models that portray the relationship between what an investor learns and how he allocates his portfolio can explain phenomena related to household behaviour in the stock market. Endogenous modelling of household learning is utilised, which builds on a growing literature called bounded rationality with increasing explanatory power, offering an alternative to the classical rational expectations theory. Such phenomena include firstly why households often hold portfolios that are little diversified, secondly why household beliefs about the stock market exhibit widespread heterogeneity despite past data being publicly available and lastly whether or not they employ strategic motives in the stock market and whether they complement others’ actions or substitute them for their own. In particular, Paper 1 addresses the observation that a significant number of investors hold concentrated portfolios, apparently forgoing the benefits of diversification. In a static portfolio choice model with limited capacity constraints, Van Nieuwerburgh & Veldkamp (2010) show that the observed lack of diversification is rational amongst investors with a strong preference for an early resolution of uncertainty. This paper studies whether or not endogenous information acquisition can also rationalise the observed peculiarity within a dynamic portfolio choice model. It is found that in the steady state, a hedging demand component appears in the optimal portfolio, which attempts to spread risk across the investor’s investment horizon: The investor chooses additional information precision the smaller is the compensation for bearing risk. A numerical approximation to the agent’s decision rule suggests that the research question can be answered in the affirmative. This is for an investor who is indifferent to the time of uncertainty resolution and is risk averse over wealth. Paper 2 tackles the question “Is demand for information positively correlated with returns?” Results from this study indicate “no” in any permanent sense. Using a dynamic model of endogenous information acquisition and portfolio choice, simulations reveal that once an agent learns the underlying process behind returns, his demand for information is constant and hence acyclical. This is surprising given survey results found by Coibion et al (2015), which, along with the PATeR survey 2014 wave, document widespread heterogeneity in agent beliefs. Hence it appears that economic agents in reality do not treat returns as though they are driven by an underlying, learnable process. This paper contributes to literature on bounded rationality and limited processing of information. It also finds a rationale for belief heterogeneity: ignoring realised returns and observing signals that support prior beliefs allows degenerate distributions to emerge. This result can be produced under the assumption that the investor does not access public information. Lastly, the third paper addresses whether or not households behave strategically regarding each other when making stock market participation decisions. The study examines the contribution of strategic considerations in stock market return expectations on the demand for risky assets empirically, exploiting novel data from the 2014 PATeR survey wave, representative of the population by age and wealth. The strategy is to identify whether individual stockholding decisions are consistent with strategic substitutes or complements prevailing in the stock market, under the null hypothesis of efficiency. The study finds evidence for strategic complementarity and additional information variables can explain this effect. Given the substantial heterogeneity in expectations and perceptions of returns, and the relatively low degree of sophistication of the median investor identified in the empirical literature, the project concludes that as strategic substitutes prevail even amongst them, a portion of the excess volatility observed in stock markets may be driven by expectational motives in coordination.

In recent years, the analysis of household financial decision making has become the main focus for both policymakers and academics. Hence this thesis first sets out to investigate the role of household financial literacy and psychological characteristics in household financial decisions. The results suggest that financial literacy is significantly associated with household financial management and practices such as credit management, cash flow management, retirement saving and investment. Further, while exploring the importance of stock market literacy on household decision to participate in the stock market, it is found that stock market literacy and trust distinctly influence the probability of household participation in the stock market. Furthermore, stock market literacy not only increases the likelihood of participation but also influences the share of wealth invested in the stock market. Also, economic shocks and future expectations are the key psychological characteristics that explain household decision to invest in stocks. However, upon participation, a larger set of psychological characteristics such as, past economic shock, future expectations, self-confidence, and time preference influence a household decision on how much to invest in stocks. Finally, the thesis examines the unwise financial decisions of households in unsecured debt management, credit card debt, mortgage debt management and investment diversification. The results show that financial distress and poverty increase the likelihood of households making unwise financial decisions. However, financial distress is found to outperform poverty in explaining the unwise financial decision of the households. Thus, the thesis brings to light the importance of financial literacy, psychological characteristics and financial distress for understanding household financial decision making.

This thesis consists of two essays on behavioral finance and financial market microstructure with computational approaches. Chapter 2 investigates the effects of steroid hormones and trader composition on financial markets in a mathematical model. We focus on the composition of traders in financial markets, namely, female traders and male traders, as risk preferences change in different ways with the mediation of steroid hormones. Firstly, we examine the effects of testosterone on financial risk preferences and market stability in the model. The results from simulation show that the effects of a more balanced gender composition are more nuanced. An increase in the proportion of female traders may actually increase the volatility of returns; however, the chances of extreme events are reduced. Secondly, we analyze the effects of cortisol on traders' risk preference and market behavior in our model with traders' risk preferences influenced by market uncertainty via the mediation of cortisol. Results from our model show that concerns about heightened market uncertainty mitigate traders' excessive risk-taking behaviors and performance of traders is largely affected by market sentiment. In the third part of Chapter 2, we examine the overall effect of testosterone and cortisol on market behavior with traders having heterogeneous behavioral and physiological responses to trading outcomes and market uncertainty. Results from simulation show that male-dominated market is less volatile as the effect of concerns about market uncertainty outweighs the effect of trading outcomes on traders' behavior. Chapter 3 examines the impact of two different types of information on high frequency market microstructure. We present a dynamic trading game in the limit order market with computerized traders and human traders trading in one risky asset, where traders might have lags in observing the contemporaneous fundamental value and the order book status. Optimal strategies and market characteristics are determined through a unique numerical technique. Our results show that these two types of information have different values for traders with information on contemporaneous fundamental value being more valuable than the information on contemporaneous limit order book status.

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This thesis studies asset pricing from three different angles. Firstly, it reveals that there is a possibility that economic shocks could damage asset pricing model performance, taking the recent 2007/2008 financial crisis and a number of recent asset pricing models as examples. Although there has been research suggesting the potential impacts of 'bad' and 'good' economic conditions on stock performance and forecasting power of economic models, this possibility remains an undiscussed idea. This is perhaps due to a range of methodological obstacles in testing the link. The thesis, therefore, proposes a new approach to overcome the issues and finds that financial shocks indeed have impacts and need to be adjusted for when assessing performance of asset pricing models. Secondly, in search for potential risk exposure associated with family ownership in pricing assets in stock markets, an examination in Turkey, a family business country, shows that family firms are not necessarily riskier that non-family firms. Instead, such ownership characteristics are associated with the sensitivity of some other risk factors. We find that within firms with low growth prospects and/or small firms, family firms outperform non-family firms and as firms grow in size and market-to-book value, nonfamily firms appear to perform better. Also, liquidity ratio, firm age and current stock prices are also among those factors which can explain the return differentials between family and non-family firms. Thirdly, privatisation with involvement of family ownership does have positive impacts on firm performance and stock return in the longrun but has negative impacts on short-term investors. An investigation on a recent privatisation deal of Tupras, the largest refineries firm in Turkey, shows that unless shareholders' investment horizon is in line with the owner family, they would not benefit from the firm long-term investment projects and could even suffer from low dividends.

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Research from the behavioural finance paradigm has detected bias in investors' decision making. One such bias, the disposition effect, shows that investors are reluctant to sell investments at a loss, yet are eager to sell investments at a gain. Investors vary in the extent to which they exhibit the disposition effect and research to date has found that an investor's level of sophistication and amount of experience can somewhat predict their susceptibility to this bias. Despite the disposition effect arising out of the nature of human psychology, few studies have empirically investigated psychological based explanations for susceptibility to this bias. I address this gap by applying two psychological theories to predict the susceptibility to the disposition effect: dual process theory and a model of the role of emotions and their regulation. The thesis contains two studies on the disposition effect of UK investors, a country where investors have not previously been researched for this bias. The first study involves using survival analysis to analyse the transactions made by 4,328 UK investors from July 2006 to December 2009. The second study is a subsample ofthe first, where 261 investors completed an online questionnaire to measure the psychological variables. I show that the average UK investor in this sample is susceptible to the disposition effect. contribute to existing knowledge about the disposition effect by showing that investor sophistication and experience attenuates, but does not eliminate, this bias. I extend knowledge on the disposition effect by showing that through the use of stop loss strategies, investors can inoculate against the disposition effect. In relation to the psychological variables, I find that investors who report higher levels of intuitive ability exhibit this bias to greater extent and investors who report a preference towards analytical cognition exhibit this bias to a lesser extent. Finally, the results tentatively show that investors who reappraise their emotions while investing, exhibit this bias to a lesser extent.

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This thesis studies household welfare and financial markets and in particular empirically examines access to finance, human capital, saving and risk sharing group formation using Indonesian households as a case study. Inefficient financial markets in developing countries lead to inefficient resource allocation, economic inequality, and high transaction costs. Households who are marginalised from financial systems find themselves unable to access financial services and smooth their consumption. The first thing to consider is how credit constraint exists and how to identify it. Credit constraints may arise from market mechanisms: demand for loans and loan supply. In order to assess credit constraints, I use Direct Elicitation Methodology (DEM) and then examine the gathered information and other household characteristics using multinomial logit model. Using Access to Finance (A2F) survey, I find that Indonesian households are likely to experience supply-side rather than demand-side constraints. I also find that financial literacy plays vital role in accessing services from formal financial institution. Moreover by elaborating several types of constraints, the welfare loss is estimated: the constrained households due to risk-related reasons experience loss in terms of annual income between Rp. 16 millions and Rp. 19 millions. In the second empirical study, I investigate the impacts of earnings risk on schooling and saving. I borrow Basu and Ghosh's model (2001) to develop a theoretical framework of two-period model, which depicts the relationship between earnings risk, schooling and saving. Using the Indonesia Family Life Survey (IFLS) data set, the decision to enter schooling is motivated by earnings risk which is measured by occupational earnings risk and earnings range or the variability between maximum and minimum earnings level across the IFLS wave. This study finds that education decrease variability over future income. Given the results that the pure risk effect is more dominant than utility smoothing effect, it can be said that to some extent saving is inadequate to anticipate the declining of household income due to earnings risk. The results also show that earnings range is close to Basu and Ghosh’s predictions. Another issue related to financial markets is the barrier to insurance for households, which also limits their capability to manage life risk. As a result, alternative risk coping mechanisms emerge to provide these households with different ways of securing insurance arrangements and in particular as risk sharing groups. In this third empirical research, I investigate the risk sharing group formation where the group is characterised by barriers to insurance. I use several tests to examine full risk sharing hypothesis, borrowing-saving hypothesis, limited commitment, moral hazard, and hidden income. Using the IFLS data set, this study provides evidence of the failure of the full risk sharing hypothesis, which is mainly due to limited commitment and moral hazard problem. Furthermore, I show that the endogenous group formation emerges within IFLS households.

The area of finance poses many challenging problems to the decision maker. One of them is the modelling of the expected return on stocks and the covariance matrix of returns. This thesis approaches the decision problem of choosing an optimum portfolio of stocks in which to invest from the point of view of statistical decision theory. We use regression methods to predict the expected monthly return on stocks and the covariance matrix between returns, the predictor variables being a company's 'fundamentals', such as dividend yield and the history of previous returns. Predictions are evaluated out of sample for shares traded on the London Stock Exchange from 1976 to 2005. Many modelling and inferential approaches are examined and evaluated, the main ones being shrinkage of regression coefficients, and transforming predictor variables to near normality. It is important to use suitable statistics to make a fair comparison of the out-of-sample performance of rival methodologies. We review well-known measures of assessing investment performance, including Sharpe, Sortino and Omega ratios, and derive a new statistic from the exponential utility function. We also suggest a graphical aid which could be used as a useful summary of investment performance.