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Does Belief Heterogeneity Explain Asset Prices: The Case of the Longshot Bias

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  • Amit Gandhi
  • Ricardo Serrano-Padial

Abstract

This article studies belief heterogeneity in a benchmark competitive asset market: a market for Arrow–Debreu securities. We show that differences in agents' beliefs lead to a systematic pricing pattern, the favourite–longshot bias (FLB): securities with a low-pay-out probability are overpriced, whereas securities with high probability pay-out are underpriced. We apply demand estimation techniques to betting market data, and find that the observed FLB is explained by a two-type population consisting of canonical traders, who hold virtually correct beliefs and are the majority type in the population (70%); and noise traders exhibiting significant belief dispersion. Furthermore, exploiting variation in public information across markets in our data set, we show that our belief heterogeneity model empirically outperforms existing preference-based explanations of the FLB.

Suggested Citation

  • Amit Gandhi & Ricardo Serrano-Padial, 2015. "Does Belief Heterogeneity Explain Asset Prices: The Case of the Longshot Bias," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 82(1), pages 156-186.
    • Handle: RePEc:oup:restud:v:82:y:2015:i:1:p:156-186
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    File URL: http://hdl.handle.net/10.1093/restud/rdu017
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    Cited by:

    1. Restocchi, Valerio & McGroarty, Frank & Gerding, Enrico & Johnson, Johnnie E.V., 2018. "It takes all sorts: A heterogeneous agent explanation for prediction market mispricing," European Journal of Operational Research, Elsevier, vol. 270(2), pages 556-569.
    2. Leighton Vaughan Williams & Ming‐Chien Sung & Peter A. F. Fraser‐Mackenzie & John Peirson & Johnnie E. V. Johnson, 2018. "Towards an Understanding of the Origins of the Favourite–Longshot Bias: Evidence from Online Poker Markets, a Real‐money Natural Laboratory," Economica, London School of Economics and Political Science, vol. 85(338), pages 360-382, April.
    3. Alan Gerber & Mitchell Hoffman & John Morgan & Collin Raymond, 2020. "One in a Million: Field Experiments on Perceived Closeness of the Election and Voter Turnout," American Economic Journal: Applied Economics, American Economic Association, vol. 12(3), pages 287-325, July.
    4. Keith Marzilli Ericson & Philipp Kircher & Johannes Spinnewijn & Amanda Starc, 2021. "Inferring Risk Perceptions and Preferences Using Choice from Insurance Menus: Theory and Evidence," The Economic Journal, Royal Economic Society, vol. 131(634), pages 713-744.
    5. Boco, Hervé & Germain, Laurent & Rousseau, Fabrice, 2016. "Heterogeneous noisy beliefs and dynamic competition in financial markets," Economic Modelling, Elsevier, vol. 54(C), pages 347-363.
    6. Bernard Salanié, 2017. "Equilibrium in Insurance Markets: An Empiricist’s View," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 42(1), pages 1-14, March.
    7. Levon Barseghyan & Francesca Molinari & Ted O'Donoghue & Joshua C. Teitelbaum, 2013. "The Nature of Risk Preferences: Evidence from Insurance Choices," American Economic Review, American Economic Association, vol. 103(6), pages 2499-2529, October.
    8. Rancière, Romain & Ouazad, Amine & Heipertz, Jonas, 2019. "The Transmission of Shocks in EndogenousFinancial Networks: A Structural Approach," CEPR Discussion Papers 13855, C.E.P.R. Discussion Papers.
    9. Jonas Heipertz & Amine Ouazad & Romain Rancière & Natacha Valla, 2017. "Balance-Sheet Diversification in General Equilibrium: Identification and Network Effects," NBER Working Papers 23572, National Bureau of Economic Research, Inc.
    10. Isabel Abinzano & Luis Muga & Rafael Santamaria, 2019. "Hidden Power of Trading Activity: The FLB in Tennis Betting Exchanges," Journal of Sports Economics, , vol. 20(2), pages 261-285, February.
    11. Bergemann, Dirk & Ottaviani, Marco, 2021. "Information Markets and Nonmarkets," CEPR Discussion Papers 16459, C.E.P.R. Discussion Papers.
    12. Zhipeng Liao & Xiaoxia Shi, 2020. "A nondegenerate Vuong test and post selection confidence intervals for semi/nonparametric models," Quantitative Economics, Econometric Society, vol. 11(3), pages 983-1017, July.
    13. Goto, Shingo & Yamada, Toru, 2023. "What drives biased odds in sports betting markets: Bettors’ irrationality and the role of bookmakers," International Review of Economics & Finance, Elsevier, vol. 86(C), pages 252-270.
    14. Bond, Philip & Dow, James, 2021. "Failing to forecast rare events," Journal of Financial Economics, Elsevier, vol. 142(3), pages 1001-1016.
    15. Niko Suhonen & Jani Saastamoinen & Mika Linden, 2018. "A dual theory approach to estimating risk preferences in the parimutuel betting market," Empirical Economics, Springer, vol. 54(3), pages 1335-1351, May.
    16. Suhonen, Niko & Saastamoinen, Jani & Kainulainen, Tuomo & Forrest, David, 2018. "Is timing everything in horse betting? Bet amount, timing and bettors’ returns in pari-mutuel wagering markets," Economics Letters, Elsevier, vol. 173(C), pages 97-99.
    17. Yu, Dian & Gao, Jianjun & Wang, Tongyao, 2022. "Betting market equilibrium with heterogeneous beliefs: A prospect theory-based model," European Journal of Operational Research, Elsevier, vol. 298(1), pages 137-151.
    18. Hegarty, Tadgh & Whelan, Karl, 2023. "Disagreement and Market Structure in Betting Markets: Theory and Evidence from European Soccer," CEPR Discussion Papers 18144, C.E.P.R. Discussion Papers.

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