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

Amit Gandhi and Ricardo Serrano-Padial

The Review of Economic Studies, 2015, vol. 82, issue 1, 156-186

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.

Date: 2015
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Persistent link: https://EconPapers.repec.org/RePEc:oup:restud:v:82:y:2015:i:1:p:156-186

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