Biased Beliefs, Asset Prices, and Investment: A Structural Approach

59 Pages Posted: 12 May 2011 Last revised: 31 Oct 2013

Aydogan Alti

University of Texas at Austin - Department of Finance

Paul C. Tetlock

Columbia Business School - Finance and Economics

Date Written: June 2013

Abstract

We structurally estimate a model in which agents' information processing biases can cause predictability in firms’ asset returns and investment inefficiencies. We generalize the neoclassical investment model by allowing for two biases -- overconfidence and over-extrapolation of trends -- that distort agents' expectations of firm productivity. Our model’s predictions closely match empirical data on asset pricing and firm behavior. The estimated bias parameters are well-identified and exhibit plausible magnitudes. Alternative models without either bias or with efficient investment fail to match observed return predictability and firm behavior. These results suggest that biases affect firm behavior, which in turn affects return anomalies.

Keywords: mispricing, market efficiency, behavioral biases, overconfidence, extrapolation, investment efficiency

JEL Classification: G10, G12, G30

Suggested Citation

Alti, Aydogan and Tetlock, Paul C., Biased Beliefs, Asset Prices, and Investment: A Structural Approach (June 2013). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1785508 or http://dx.doi.org/10.2139/ssrn.1785508

Aydogan Alti (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States

Paul C. Tetlock

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9895 (Fax)

HOME PAGE: http://www0.gsb.columbia.edu/faculty/ptetlock/

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