Cognitive Biases, Ambiguity Aversion and Asset Pricing in Financial Markets

Abstract:     
Agents with cognitive limitations may compute the expected value of a risky asset incorrectly. If market prices reflect the probabilities of the payoff-relevant states, agents who compute the probabilities incorrectly encounter a market price that is inconsistent with their calculation. We test whether observing the market price makes agents lose confidence in their own calculations. We hypothesize that agents who lose confidence in their own calculations seek to avoid the uncertainty by acquiring a portfolio that generates a sure return. They then become price insensitive: they do not adjust their portfolio with changes in relative prices, and therefore they do not affect prices. We identify price insensitive agents in an experiment, and we test three implications of our hypothesis: (i) price quality is inversely related to the proportion of price-insensitive agents; (ii) price-insensitive subjects hold more balanced portfolios, and (iii) price insensitive subjects trade less. Our experiments strongly confirm the first two hypotheses and provide some evidence in support of the third, reinforcing our view that market prices trigger ambiguity averse decisions.

Keywords: asset pricing, ambiguity aversion, cognitive

JEL Classifications: G11, G12, G14

Working Paper Series