Taking our cue from certain recent advances in experimental psychology, we propose a plausible theory of conflict between rationality and inherent behavioral biases of investors. In this theory no investor is fully rational or fully behavioral at all times. An investor faces a continuum between behavioral and rational positions. A movement toward rationality is a choice; it is costly to be fully rational which requires serious mental calculations. On the other hand, there could be some benefits to rationality in special circumstances which compensate for the costs. Using a unique and extensive investor-level database, we show that the degree of non-rationality decreases as rational behavior becomes more attractive. In our empirical setting, the proxy for rational behavior is investor’s use of private pre-disclosure information during earnings announcement periods, while the disposition effect they display serves as an estimate of their behavioral bias. The paper contributes to the existing literature in several dimensions.

JEL Classification: D81, D82, D83, G11, G12, G14

Keywords: Private Information, Information Asymmetry, Disposition Effect, Post-Earnings Announcement Drift