Working Paper: NBER ID: w20875
Authors: Nicola Gennaioli; Andrei Shleifer; Robert Vishny
Abstract: We model a financial market in which investor beliefs are shaped by representativeness. Investors overreact to a series of good news, because such a series is representative of a good state. A few bad news do not change investor minds because the good state is still representative, but enough bad news leads to a radical change in beliefs and a financial crisis. The model generates debt over-issuance, “this time is different” beliefs, neglect of tail risks, under- and over-reaction to information, boom-bust cycles, and excess volatility of prices in a unified psychological model of expectations.
Keywords: No keywords provided
JEL Codes: G01; G02
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Investor beliefs shaped by representativeness (G41) | Overreaction to good news (G41) |
| Overreaction to good news (G41) | Neglect of bad outcomes (D91) |
| Neglect of bad outcomes (D91) | Accumulation of bad news (E32) |
| Accumulation of bad news (E32) | Perceived probability of financial crisis increases (G01) |
| Investor beliefs shaped by representativeness (G41) | Excessive debt issuance during boom periods (H63) |
| Accumulation of bad news (E32) | Transition from neglect to overreaction (D91) |
| Transition from neglect to overreaction (D91) | Market volatility increases (G17) |
| Transition from neglect to overreaction (D91) | Financial crises occur (G01) |