IDEAS home Printed from https://ideas.repec.org/p/red/sed016/1358.html
   My bibliography  Save this paper

Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?

Author

Listed:
  • Raman Uppal

    (Edhec Business School)

  • Harjoat Bhamra

    (Imperial College Business School)

Abstract

A common criticism of behavioral economics is that it has not shown that individual investors' biases lead to aggregate long-run effects on both asset prices and macroeconomic quantities. Our objective is to address this criticism in a production economy where individual portfolio biases cancel when summed across investors, but still have an effect on aggregate quantities in the long-run. We solve in closed form a model of a stochastic general-equilibrium production economy with a large number of heterogeneous firms and investors. Investors are ambiguity averse, so they hold portfolios biased toward familiar assets. We specify this bias to be unsystematic - it cancels out when aggregated across investors. However, each investor bears more risk than necessary, which distorts the consumption of all investors in the same direction. Hence, distortions in consumption do not cancel out in aggregate and increasing the price of risk and distorting aggregate investment and growth. The increased risk from holding biased portfolios, which increases the demand for the risk-free asset, leading to a higher equity risk premium and lower risk-free rate that match empirical values. Our analysis illustrates that idiosyncratic behavioral biases can have long-run distortionary effects on both financial markets and the macroeconomy

Suggested Citation

  • Raman Uppal & Harjoat Bhamra, 2016. "Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?," 2016 Meeting Papers 1358, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:1358
    as

    Download full text from publisher

    File URL: https://economicdynamics.org/meetpapers/2016/paper_1358.pdf
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Macroeconomic Risk," American Economic Review, American Economic Association, vol. 97(2), pages 1-30, May.
    2. Laurent E. Calvet & John Y. Campbell & Paolo Sodini, 2007. "Down or Out: Assessing the Welfare Costs of Household Investment Mistakes," Journal of Political Economy, University of Chicago Press, vol. 115(5), pages 707-747, October.
    3. Nataliya Barasinska & Dorothea Schäfer & Andreas Stephan, 2008. "Financial Risk Aversion and Household Asset Diversification," Discussion Papers of DIW Berlin 807, DIW Berlin, German Institute for Economic Research.
    4. repec:hrv:faseco:33077905 is not listed on IDEAS
    5. Elyès Jouini & Clotilde Napp, 2007. "Consensus Consumer and Intertemporal Asset Pricing with Heterogeneous Beliefs," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1149-1174.
    6. Shefrin, Hersh, 2008. "A Behavioral Approach to Asset Pricing," Elsevier Monographs, Elsevier, edition 2, number 9780123743565.
    7. Matteo Pelagatti & Pranab Sen, 2009. "A robust version of the KPSS test based on ranks," Working Papers 20090701, Università degli Studi di Milano-Bicocca, Dipartimento di Statistica.
    8. Michael Haliassos, 2002. "Stockholding: Recent Lessons from Theory and Computations," University of Cyprus Working Papers in Economics 0206, University of Cyprus Department of Economics.
    9. Nicholas Barberis & Ming Huang & Richard H. Thaler, 2006. "Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing," American Economic Review, American Economic Association, vol. 96(4), pages 1069-1090, September.
    10. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does It Work?," Management Science, INFORMS, vol. 54(11), pages 1935-1950, November.
    11. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Economic Risk," NBER Working Papers 12948, National Bureau of Economic Research, Inc.
    12. Beeler, Jason & Campbell, John Y., 2012. "The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment," Critical Finance Review, now publishers, vol. 1(1), pages 141-182, January.
    13. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring.
    14. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," Econometrica, Econometric Society, vol. 77(6), pages 1711-1750, November.
    15. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
    16. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272.
    17. Basak, Suleyman, 2005. "Asset pricing with heterogeneous beliefs," Journal of Banking & Finance, Elsevier, vol. 29(11), pages 2849-2881, November.
    18. Shefrin, Hersh, 2007. "Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing," OUP Catalogue, Oxford University Press, number 9780195304213.
    19. Harrison Hong & Jeffrey D. Kubik & Jeremy C. Stein, 2005. "Thy Neighbor's Portfolio: Word-of-Mouth Effects in the Holdings and Trades of Money Managers," Journal of Finance, American Finance Association, vol. 60(6), pages 2801-2824, December.
    20. Herskovic, Bernard & Kelly, Bryan & Lustig, Hanno & Van Nieuwerburgh, Stijn, 2016. "The common factor in idiosyncratic volatility: Quantitative asset pricing implications," Journal of Financial Economics, Elsevier, vol. 119(2), pages 249-283.
    21. Camerer, Colin & Weber, Martin, 1992. "Recent Developments in Modeling Preferences: Uncertainty and Ambiguity," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 325-370, October.
    22. French, Kenneth R. & Poterba, James M., 1990. "Japanese and U.S. cross-border common stock investments," Journal of the Japanese and International Economies, Elsevier, vol. 4(4), pages 476-493, December.
    23. Hongjun Yan, 2010. "Is Noise Trading Cancelled Out by Aggregation?," Management Science, INFORMS, vol. 56(7), pages 1047-1059, July.
    24. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, August.
    25. Arrondel, Luc & Lefebvre, Bruno, 2001. "Behavior of Household Portfolios in France: The Role of Housing," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 47(4), pages 489-514, December.
    26. Baldauf, Markus & Santos Silva, J.M.C., 2012. "On the use of robust regression in econometrics," Economics Letters, Elsevier, vol. 114(1), pages 124-127.
    27. Harrison Hong & Jeremy C. Stein, 1999. "A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets," Journal of Finance, American Finance Association, vol. 54(6), pages 2143-2184, December.
    28. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    29. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-969, July.
    30. Schroder, Mark & Skiadas, Costis, 1999. "Optimal Consumption and Portfolio Selection with Stochastic Differential Utility," Journal of Economic Theory, Elsevier, vol. 89(1), pages 68-126, November.
    31. David Ahn & Syngjoo Choi & Douglas Gale & Shachar Kariv, 2014. "Estimating ambiguity aversion in a portfolio choice experiment," Quantitative Economics, Econometric Society, vol. 5, pages 195-223, July.
    32. Shefrin, Hersh & Statman, Meir, 1994. "Behavioral Capital Asset Pricing Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(03), pages 323-349, September.
    33. Tony Berrada, 2009. "Bounded Rationality and Asset Pricing with Intermediate Consumption," Review of Finance, European Finance Association, vol. 13(4), pages 693-725.
    34. repec:dau:papers:123456789/78 is not listed on IDEAS
    35. Lars Peter Hansen, 2014. "Nobel Lecture: Uncertainty Outside and Inside Economic Models," Journal of Political Economy, University of Chicago Press, vol. 122(5), pages 945-987.
    36. Valery Polkovnichenko, 2005. "Household Portfolio Diversification: A Case for Rank-Dependent Preferences," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1467-1502.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed016:1358. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann). General contact details of provider: http://edirc.repec.org/data/sedddea.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.