Working Paper: CEPR ID: DP16335
Authors: Raman Uppal; Harjoat Singh Bhamra
Abstract: A major criticism of behavioral economics is that it has not shown that the idiosyncratic biases of individual investors lead to aggregate effects. We construct a model of a general-equilibrium production economy with a large number of firms and investors. Investors' beliefs about stock returns are determined endogenously based on their psychological distances from firms; consequently, investors are optimistic about some stocks and pessimistic about others. We consider two examples: one where portfolio errors cancel out and the other in which the behavioral biases cancel out when aggregated across investors. We show asset prices and macroeconomic aggregates are still distorted.
Keywords: behavioral finance; money market; aggregate growth; stochastic discount factor
JEL Codes: G02; E03; E44; G11; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Individual investors' psychological biases (G41) | Portfolio errors (G11) |
| Portfolio errors (G11) | Distortion of asset prices (G19) |
| Portfolio errors (G11) | Distortion of macroeconomic variables (E39) |
| Individual investors' psychological biases (G41) | Distortion of asset prices (G19) |
| Individual investors' psychological biases (G41) | Influence on interest rate (E43) |
| Individual investors' psychological biases (G41) | Influence on market price of risk (G19) |
| Individual investors' psychological biases (G41) | Impact on mean of stochastic discount factor (D15) |
| Individual investors' psychological biases (G41) | Impact on volatility of stochastic discount factor (G17) |