Speculating on Higher Order Beliefs

71 Pages Posted: 14 Mar 2024

See all articles by Paul Schmidt-Engelbertz

Paul Schmidt-Engelbertz

Yale School of Management

Kaushik Vasudevan

Mitchell E. Daniels, Jr School of Business, Purdue University

Date Written: February 15, 2024

Abstract

Higher order beliefs - beliefs about others' beliefs - may be important for trading behavior and asset prices, but have received little systematic empirical examination. We study more than twenty years of evidence from the Robert Shiller Investor Confidence surveys, which directly elicit details on investors' higher order beliefs about the U.S. stock market. We find that investors' higher order beliefs provide substantial motivations for non-fundamental speculation, e.g., to buy into a stock market perceived to be overvalued. To explore the general equilibrium implications, we construct a model of level k thinking that matches the evidence, where investors believe that asset price movements are driven by other, less sophisticated investors. The model reveals that investors' higher order beliefs amplify stock market overreaction and excess volatility. These phenomena persist in equilibrium due to investors' limited strategic reasoning.

Suggested Citation

Schmidt-Engelbertz, Paul and Vasudevan, Kaushik, Speculating on Higher Order Beliefs (February 15, 2024). Available at SSRN: https://ssrn.com/abstract=4728936 or http://dx.doi.org/10.2139/ssrn.4728936

Paul Schmidt-Engelbertz

Yale School of Management ( email )

165 Whitney Ave
New Haven, CT 06511

Kaushik Vasudevan (Contact Author)

Mitchell E. Daniels, Jr School of Business, Purdue University ( email )

403 Mitch Daniels Blvd.
West Lafayette, IN 47907
United States

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