Mental Models of the Stock Market

92 Pages Posted: 30 Oct 2023 Last revised: 5 Nov 2024

See all articles by Peter Andre

Peter Andre

Leibniz Institute for Financial Research SAFE; Goethe University Frankfurt

Philipp Schirmer

University of Bonn

Johannes Wohlfart

University of Copenhagen

Multiple version iconThere are 3 versions of this paper

Date Written: November 1, 2024

Abstract

Investors' return expectations are pivotal in stock markets, but the reasoning behind these expectations is not well understood. This paper sheds light on economic agents' mental models -- their subjective understanding -- of the stock market. We conduct surveys with the general population, retail investors, financial professionals, and academic experts. Respondents forecast and explain how future returns respond to stale news about the future earnings streams of companies. We document four main results. First, while academic experts view stale news as irrelevant, households and professionals often believe that stale good news leads to persistently higher expected future returns. Second, academic experts refer to market efficiency to explain their forecasts, whereas households and many professionals directly equate higher future earnings with higher future returns, neglecting the offsetting effects of endogenous price adjustments. Third, additional experiments with households demonstrate that this neglect of equilibrium pricing does not reflect inattention to trading or price responses or ignorance about how returns are calculated. Instead, it reflects a gap in respondents' mental models: they are unfamiliar with the concept of equilibrium pricing. Lastly, we illustrate the potential consequences of neglecting equilibrium pricing. We use panel data on household expectations to show that this neglect predicts previously documented belief anomalies such as return extrapolation and pro-cyclicality.

Keywords: Expectation Formation, Mental Models, Return Expectations, Neglect of Equilibrium Pricing

JEL Classification: D83, D84, G11, G12, G41, G51, G53

Suggested Citation

Andre, Peter and Schirmer, Philipp and Wohlfart, Johannes, Mental Models of the Stock Market (November 1, 2024). SAFE Working Paper No. 406, Available at SSRN: https://ssrn.com/abstract=4589777 or http://dx.doi.org/10.2139/ssrn.4589777

Peter Andre

Leibniz Institute for Financial Research SAFE ( email )

House of Finance
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Goethe University Frankfurt

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Philipp Schirmer

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Johannes Wohlfart (Contact Author)

University of Copenhagen ( email )

Nørregade 10
Copenhagen, København DK-1165
Denmark

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