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Distorted Beliefs and Asset Prices

Author

Listed:
  • Lorenzo Bretscher

    (Swiss Finance Institute - HEC Lausanne; Centre for Economic Policy Research (CEPR))

  • Aytek Malkhozov

    (McGill University)

  • Andrea Tamoni

    (University of Notre Dame - Mendoza College of Business)

  • Haoxi Yang

    (USun Yat-sen University (SYSU) - Lingnan (University) College)

Abstract

We investigate the role of distorted beliefs in the stock market, particularly their impact on risk premia. We identify the bias in investors' expectations stemming from belief distortions and decompose the predictable component of market returns into investors' beliefs about future returns and their bias. We then show that shocks to this bias, because it manifests itself as discount-rate risk in the data but represents cash-flow risk from investors' perspective, emerges as a priced risk factor. Our findings indicate that distorted beliefs impact both the time series and cross-section of expected returns, helping to explain observed deviations from theoretical predictions under rational expectations.

Suggested Citation

  • Lorenzo Bretscher & Aytek Malkhozov & Andrea Tamoni & Haoxi Yang, 2024. "Distorted Beliefs and Asset Prices," Swiss Finance Institute Research Paper Series 24-66, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2466
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4947547
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    More about this item

    Keywords

    distorted beliefs; return predictability; ICAPM; cross-section of stock returns;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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