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Title: Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?

Author(s): Harjoat Singh Bhamra and Raman Uppal

Publication Date: November 2017

Keyword(s): aggregate growth, ambiguity aversion, behavioral finance, investment and underdiversification

Programme Area(s): Financial Economics

Abstract: A common criticism of behavioral economics is that it has not shown that the psychological biases of individual investors lead to aggregate long-run effects on both asset prices and macroeconomic quantities. Our objective is to address this criticism by providing a simple example of a production economy where individual portfolio biases cancel when summed across investors, but still have an effect on aggregate quantities that does not vanish in the long-run. Specifically, we solve in closed form a model of a stochastic general-equilibrium production economy with a large number of heterogeneous firms and investors. Investors in our model are averse to ambiguity and so hold portfolios biased toward familiar assets. We specify this bias to be unsystematic so it cancels out when aggregated across investors. However, because of holding underdiversified portfolios, investors bear more risk than necessary, which distorts the consumption of all investors in the same direction. Hence, distortions in consumption do not cancel out in the aggregate and therefore increase the price of risk and distort 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 a lower risk-free rate that match the values observed empirically. Furthermore, all investors survive in the long-run, and so the effects of their biases never vanish. Our analysis illustrates that idiosyncratic behavioral biases can have long-run distortionary effects on both financial markets and the macroeconomy.

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Bibliographic Reference

Bhamra, H and Uppal, R. 2017. 'Do Individual Behavioral Biases Affect Financial Markets and the Macroeconomy?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=12415