Do Behavioral Biases Adversely Affect the Macro-Economy?
Review of Financial Studies, Forthcoming
72 Pages Posted: 11 Aug 2008 Last revised: 17 Sep 2010
Date Written: September 14, 2010
We investigate whether the adverse effects of investors’ behavioral biases extend beyond the domain of financial markets to the broad macro-economy. Focusing on the income risk-sharing role of financial markets, we find that risk-sharing is higher (more than double) in U.S. states where investors are more sophisticated and exhibit weaker behavioral biases. The potential for risk-sharing varies geographically but states with better risk-sharing opportunities are able to achieve higher levels of risk sharing only when investors in those states are more sophisticated. Collectively, these results indicate that investors’ aggregate behavioral biases and their lack of financial sophistication adversely affect the local macroeconomy.
Keywords: Risk sharing, income risk, financial markets, cognitive abilities, behavioral biases, investor sophistication
JEL Classification: E10, G11, G12
Suggested Citation: Suggested Citation