Beliefs and Portfolios: Causal Evidence
71 Pages Posted: 8 Feb 2022 Last revised: 24 Sep 2023
Date Written: September 21, 2023
We causally test alternative theories of expectation formation and asset pricing. Using a randomized information experiment we show overreaction is a key feature of individuals’ belief formation. Individuals excessively extrapolate past returns and earnings growth into future returns. The average response to the price-earnings ratio is opposite to the academic consensus and individuals’ reaction to stock market news depends on their information preference. Conditional on their beliefs, individuals’ choices are consistent with the standard Merton model of portfolio choice. Our evidence suggests belief overreaction and heterogeneous subjective mental models as key ingredients to asset pricing models.
Keywords: Expectation formation, asset pricing, household finance
JEL Classification: G11, G12, G41, G51, G53, D84, E44
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