Mental Models of the Stock Market

Peter Andre, Philipp Schirmer () and Johannes Wohlfart ()
Additional contact information
Philipp Schirmer: University of Bonn
Johannes Wohlfart: University of Copenhagen

No 259, ECONtribute Discussion Papers Series from University of Bonn and University of Cologne, Germany

Abstract: Investors’ return expectations are pivotal in stock markets, but the reasoning behind these expectations remains a black box for economists. This paper sheds light on economic agents’ mental models – their subjective understanding – of the stock market. We conduct surveys with the general population, retail investors, financial professionals, and academic experts. Respondents forecast and explain how future returns respond to stale news about the future earnings streams of companies. We document four main results. First, while academic experts view stale news as irrelevant, households and professionals often believe that stale good news leads to persistently higher expected future returns. Second, while academic experts refer to market efficiency to explain their forecasts, households and many professionals directly equate higher future earnings with higher future returns, neglecting the offsetting effect of endogenous price adjustments. Third, additional experiments with households demonstrate that this neglect of equilibrium pricing does not reflect inattention to trading or price responses but rather a gap in respondents’ mental models: they are unfamiliar with the concept of equilibrium. Lastly, we illustrate the consequences of equilibrium neglect. We use panel data on household expectations to show that equilibrium neglect predicts previously documented belief anomalies such as return extrapolation and pro-cyclicality.

JEL-codes: D83 D84 G11 G12 G41 G51 G53 (search for similar items in EconPapers)
Pages: 75 pages
Date: 2023-10
New Economics Papers: this item is included in nep-fmk and nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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https://www.econtribute.de/RePEc/ajk/ajkdps/ECONtribute_259_2023.pdf First version, 2023 (application/pdf)

Related works:
Working Paper: Mental Models of the Stock Market (2024)
Working Paper: Mental Models of the Stock Market (2024)
Working Paper: Mental Models of the Stock Market (2023)
Working Paper: Mental models of the stock market (2023)
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