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The Social Cost of Near-Rational Investment

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  • Tarek A. Hassan
  • Thomas M. Mertens

Abstract

We show that the stock market may fail to aggregate information even if it appears to be efficient, and that the resulting decrease in the information content of prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors when forming expectations about future productivity. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When prices reflect less information, the conditional variance of stock returns rises, causing an increase in uncertainty and costly distortions in consumption, capital accumulation, and labor supply.

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  • Tarek A. Hassan & Thomas M. Mertens, 2016. "The Social Cost of Near-Rational Investment," Working Paper Series 2016-16, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:2016-16
    DOI: 10.24148/wp2016-16
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    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • E02 - Macroeconomics and Monetary Economics - - General - - - Institutions and the Macroeconomy
    • E03 - Macroeconomics and Monetary Economics - - General - - - Behavioral Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises

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