Beliefs and Portfolios: Causal Evidence

Abstract

We causally test alternative theories of expectation formation. Using a randomized information experiment we show overreaction is a key feature of individuals' return expectations, and individuals' response to the price-earnings ratio is opposite to the academic consensus. Our evidence is inconsistent with standard models of expectation formation but subjective mental models that deviate from objective benchmarks can jointly explain the updating behavior in the experiment, the link between individuals' prior perceptions and expectations, and the heterogeneity of their updating behavior. Conditional on their beliefs, individuals' sensitivity of risky portfolio shares is consistent with the standard Merton model of portfolio choice.

Keywords: Expectation formation, asset pricing, household finance

JEL Classification: G11, G12, G41, G51, G53, D84, E44