The Social Cost of Near-Rational Investment
Tarek A. Hassan
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Thomas M. Mertens
New York University (NYU) - Department of Finance
May 10, 2014
NYU Working Paper No. 2451/29843
We show that the stock market may fail to aggregate information even if it appears to be efficient; the resulting collapse in the dissemination of information may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors around their optimal investment policies. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When stock prices reflect less information, the perceived and the actual volatility of stock returns rise. This increase in financial risk makes holding stocks unattractive, distorts the long-run level of capital accumulation, and causes costly ( first-order) distortions in the long-run level of consumption.
Number of Pages in PDF File: 70
Date posted: November 8, 2010 ; Last revised: May 19, 2014
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