DP14647 Why so Negative? Belief Formation and Risk Taking in Boom and Bust Markets

Author(s): Pascal Kieren, Jan Mueller-Dethard, Martin Weber
Publication Date: April 2020
Date Revised: May 2021
Keyword(s): Belief formation, Market Cycles, Return Expectations, risk-taking
JEL(s): D83, D84, E32, E44, G01, G11, G41
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14647

An increasing number of studies depart from the rational expectations assumption to reconcile survey expectations with asset prices. While surveys are helpful to establish a link between subjective beliefs and investment decisions, they do not allow inference about how investors depart from rational expectations. In this paper, we provide direct experimental evidence of how systematic distortions in investors' expectations affect their risk-taking across market cycles. As mechanism, we identify an asymmetry in how individuals update their expectations across boom and bust markets. The documented mechanism is consistent with survey data and provides important implications for recently proposed asset pricing models.