DP16335 Do the Effects of Individual Behavioral Biases Cancel Out?

Author(s): Harjoat Singh Bhamra, Raman Uppal
Publication Date: July 2021
Keyword(s): aggregate growth, behavioral finance, money market, Stochastic discount factor
JEL(s): E03, E44, G02, G11, G41
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16335

A major criticism of behavioral economics is that it has not shown that the idiosyncratic biases of individual investors lead to aggregate effects. We construct a model of a general-equilibrium production economy with a large number of firms and investors. Investors' beliefs about stock returns are determined endogenously based on their psychological distances from firms; consequently, investors are optimistic about some stocks and pessimistic about others. We consider two examples: one where portfolio errors cancel out and the other in which the behavioral biases cancel out when aggregated across investors. We show asset prices and macroeconomic aggregates are still distorted.