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Underlying the failure of CML was an overly simple model that assumed efficient and complete markets. There are, however, problems with externalities and weak or absent insurance markets, especially in developing countries, that these models did not consider. This chapter focuses on major categories of ‘market failures’. It examines the direct externalities associated with capital flows, and looks at how capital market liberalization can exacerbate the problems posed by coordination failures and broader macroeconomic failures. It also looks at the effect of imperfect information on investor behavior and the market failures associated with capital markets. It concludes with a discussion of the major objectives of government intervention.

This chapter argues that the behavioural portfolio theory offers a good description of investor behaviour and a basis for good policy prescriptions. The theory states that investors view with portfolios not as a whole, but as distinct layers in a pyramid of assets where layers are associated with specific goals, and where attitudes towards risk vary across layers. Unlike the mean-variance theory which offers portfolio descriptions that investors do not follow, the behavioural portfolio theory offers prescription of pyramid portfolios that are closer to reality.

This chapter compares trends in financial integration within Asia with those in industrialized countries and other regional groups. Declines in cross-country dispersion in equity returns and interest rates suggest increased Asian integration, with the process interrupted by crises and global volatility. Cross-border equity and bond holdings have also increased, but Asian countries remain considerably more financially integrated with major countries outside the region than with those within the region. The chapter also discusses whether potential benefits of regional financial integration, such as increased risk-sharing and stability of the investor base, have materialized.

This chapter examines the emergence and consequences of a vernacular “science of financial investments.” While many eighteenth-century writers saw financial knowledge as devilish and destructive (centered upon the bodily and verbal skills required by street transactions), these new authors set out to build a science of investments grounded in observation and calculation. Among the main outcomes of this process are the rationalization of investor behavior and the representation of financial markets as supra-individual, quasi-natural entities, which cannot be controlled by any group. It is the latter notion which allowed for the shift to price behavior as the core actor of abstract market models. The effort to transform investment knowledge into a science is crowned by the formulation of basic views of the random walk hypothesis. The first mathematical formulation of the random walk hypothesis plays a decisive role in the development of mathematical finance (more specifically, of the options pricing theory). The main tenet of the random walk hypothesis is that securities prices move independently of each other, and that future movements do not depend on past movements. One of the most important implications of this hypothesis is that in the long run, the market cannot be controlled by any group or person.

Traditional finance explains individual investor’s behavior and financial decision making based on economic incentives and rationality. Modern finance, however, takes a holistic view and searches for not only economic but also biological, psychological, and social factors that shape decision making. In this new approach, genetics, life experiences, psychological traits, social norms, and peer influences, as well as beliefs, values, and culture help determine an investor’s stock market participation, equity holdings, frequency of trading, extent of diversification, and investment preferences. The collective preferences and actions of individual investors also have an impact on asset pricing and corporate decisions.

After appearing to be such a success for most of the last century, securities regulation as an endeavor is now under great stress. This chapter lays the groundwork for exploring why. Although some of this is a matter of politics and economics, the chapter stresses diversity in investors, in human behavior, and in patterns of competitiveness in the face of immensely powerful incentives. Investors can be biased, but so can the sell-side: indeed, cognitive traits like overconfidence and overoptimism can be highly adaptive. From these perspectives, the chapter takes on debates over market efficiency, disclosure effectiveness, high-frequency trading, regulatory arbitrage, and federalism. It introduces the pervasive self-deception at the heart of much financial behavior.

This chapter suggests that investment schemes should be redesigned according to a location’s sustainable development objectives and the potential contributions of FDI toward sustainable development. Not only will this help to avoid wasteful or inefficient incentives, the authors argue, but, by promoting sustainable development through incentive programs, governments could improve the viability of important investments (such as in electricity, water supply, health and education services), making those services more accessible and affordable for the poor, and the jurisdiction a more attractive investment destination.

The model makes a clear distinction between the household and business sectors, as the utility function of managers differs from that of households. Companies can be valued in two separate ways, through the ‘replacement cost’ of their assets and that ascribed to them by the stock market. For simplification it divides financial assets into three classes, cash, bonds, and equities, rather than by treating bonds as having a range of maturities. Short-term fluctuations in equity prices are random but in the longer term they are predictable, as returns are mean reverting, but as the timing and level of changes are not known, arbitrage does not eliminate the fluctuations. Longer-term returns are determined by the different risk aversions of investors and corporate managers. Investors’ portfolio preferences vary with demographics and adjust to corporate leverage without changing equity returns.

The net effect of these changes in investors’ time horizons can be seen from the willingness of the household sector to hold equity. Household ownership of quoted equity has fallen when measured by corporate net worth and risen when measured at market value. The level of the stock market is determined by fluctuations in investors’ confidence, so the rise in household ownership measured at market prices combined with a fall measured at net worth indicates a fall in the long-term willingness to hold equity offset by a fluctuating but marked upward trend in investors’ short-term confidence. Government borrowing affects the extent to which changes in aggregate risk aversion are reflected in corporate leverage as do flows of funds from abroad. The main post-war changes have been the steady rise in business debt, the reduction in government debt from 1946 to 1981 and its subsequent rise to new heights, the long-term fall and subsequent recovery after 2007 in household net debt assets and the rise in foreign debt ownership.

The model differs from the neoclassical synthesis by emphasizing the need to divide the private sector between the household and corporate sectors, as business managers do not act as if they were at the direct behest of shareholders. Companies do not ‘profit maximize’. Bond yields and equity returns are derived independently. Contrary to the Miller-Modigliani Theorem the cost of capital, and thus the value of the produced capital stock, varies with leverage. The risk aversion of investors results in the mean reversion of real equity returns at around 6.7 per cent and applies internationally. Corporate decisions are made by managers whose behaviour is determined by a utility function which is different from that which determines the portfolio preferences of the owners of capital.

The United States is unique in that it is the only country for which we have data for equity returns over 217 years. Reliable data on other markets are generally available only since 1900 and we have complete data for fifteen of these, which fall into two groups, eight of which suffered major losses of capital destruction, either through being defeated and occupied in one or both of two world wars or from civil war. Stock-market returns are similar for the countries that did not suffer such losses, while rapid growth allowed those that did suffer to catch up in terms of output, but the capital losses were not made good by subsequent higher returns. An international comparison shows that economic growth is not related to equity returns. In the absence of capital losses through war, which not surprisingly were unexpected, the similarity of returns, their negative serial correlation, and their lack of relationship with growth, indicates that the risk aversion of investors appears to be the same worldwide.