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Cognitive Biases, Ambiguity Aversion and Asset Pricing in Financial Markets

Author

Listed:
  • Elena Asparouhova

    (University of Utah)

  • Peter Bossaerts

    (Caltech, EPFL Lausanne and CEPR)

  • Jon Eguia

    (NYU)

  • William Zame

    (UCLA)

Abstract

Agents with cognitive limitations may compute the expected value of a risky asset incorrectly. If market prices reflect the probabilities of the payoff-relevant states, agents who compute the probabilities incorrectly encounter a market price that is inconsistent with their calculation. We test whether observing the market price makes agents lose confidence in their own calculations. We hypothesize that agents who lose confidence in their own calculations seek to avoid the uncertainty by acquiring a portfolio that generates a sure return. They then become price insensitive: they do not adjust their portfolio with changes in relative prices, and therefore they do not affect prices. We identify price insensitive agents in an experiment, and we test three implications of our hypothesis: (i) price quality is inversely related to the proportion of price-insensitive agents; (ii) price-insensitive subjects hold more balanced portfolios, and (iii) price-insensitive subjects trade less. Our experiments strongly confirm the first two hypotheses and provide some evidence in support of the third, reinforcing our view that market prices trigger ambiguity averse decisions.

Suggested Citation

  • Elena Asparouhova & Peter Bossaerts & Jon Eguia & William Zame, "undated". "Cognitive Biases, Ambiguity Aversion and Asset Pricing in Financial Markets," Swiss Finance Institute Research Paper Series 09-20, Swiss Finance Institute.
  • Handle: RePEc:chf:rpseri:rp0920
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    File URL: http://ssrn.com/abstract=1405415
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    More about this item

    Keywords

    Asset pricing; ambiguity aversion; cognitive bias; Bayesian updating; market experiments.;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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