Distorted Beliefs and Asset Prices

Lorenzo Bretscher, Aytek Malkhozov, Andrea Tamoni and Haoxi Yang
Additional contact information
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

No 24-66, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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.

Keywords: distorted beliefs; return predictability; ICAPM; cross-section of stock returns (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2024-10
New Economics Papers: this item is included in nep-rmg and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2466

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