Essays on Individual Investor Behavior and Asset Allocation

This dissertation considers issues related to how market factors and psychological biases impact the investment choices of individuals.;In this first chapter, I conduct an empirical analysis using data from multiple asset classes to ask whether bubbles can explain the time-variation in crash risk. In the first part of the chapter, I measure crash risk using the skewness of the distribution of daily returns. I find that bubbles can indeed explain the variation in skewness over time, and find little evidence that crash risk is driven by fundamentals. In the second part of the chapter, however, I use a probit model to directly measure the probability of a large monthly decline, and I find the opposite result: the probability of a crash is highest after prices have gone down. In fact, across all asset classes, I find evidence against bubbles driving the risk of a major crash, and similar results hold when conducting an analysis of daily crashes. Instead, I find that bubbles tend to diffuse slowly rather than quickly in all asset markets and that investors who want to measure crash risk in the US stock market should concentrate on forecasting volatility rather than predicting whether there is a bubble in the market.;In the second chapter. I ask why structured products are increasing in popularity. Structured products are investments for individuals that combine traditional assets, such as stocks or bonds, with derivative assets. These assets allow the investor more freedom to customize the risk profile of their investment. A common type of structured product involves a portfolio insurance strategy: sacrificing a fraction of upside potential in exchange for insuring returns from going below a certain level. Economists, though, have found it difficult to explain why these assets are so popular, as expected utility investors would be better off investing in a combination of a stock and risk free asset. Previous research, however, has shown that individuals frame gambles narrowly, meaning that they evaluate each gamble in isolation. In this chapter, I show that if investors frame gambles narrowly, then investors will indeed invest in portfolio insurance. The optimal combination of the stock and risk free asset will no longer be desirable due to narrow framing, but since the structured product can be framed as one asset, narrow framing investors will prefer this asset.;In the last chapter, I study the extent to which an understanding of diversification benefits impacts investment choices such as whether an individual participates in the stock market or allocates any savings towards foreign stocks. Investors should understand that idiosyncratic risk can be diversified away, as well as be aware of the importance of an asset's correlation with aggregate risk. I develop an original survey to test this understanding, and conduct the survey on the Yale School of Management's online eLab system. I do indeed find that an understanding of diversification benefits has a significant impact on stock market participation, but there is little evidence that it causes investors to shy away from foreign stock.