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Mental Models of the Stock Market

Peter Andre (), Philipp Schirmer () and Johannes Wohlfart ()
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Peter Andre: SAFE and Goethe University Frankfurt
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, drawing on surveys with the US general population, US retail investors, US financial professionals, and academic experts. Respondents make return forecasts in scenarios describing stale news about the future earnings streams of companies, and we collect rich data on respondents’ reasoning. We document three main results. First, inference from stale news is rare among academic experts but common among households and financial professionals, who believe that stale good news lead to persistently higher expected returns in the future. Second, while experts refer to the notion of market effi-ciency to explain their forecasts, households and financial professionals reveal a neglect of equilibrium forces. They naively equate higher future earnings with higher future returns, neglecting the offsetting effect of endogenous price adjustments. Third, a se-ries of experimental interventions demonstrate that these naive forecasts do not result from inattention to trading or price responses but reflect a gap in respondents’ mental models – a fundamental unfamiliarity with the concept of equilibrium.

JEL-codes: D83 D84 G11 G12 G41 G51 G53 (search for similar items in EconPapers)
Pages: 67 pages
Date: 2023-10
New Economics Papers: this item is included in nep-fmk and nep-mst
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Downloads: (external link) First version, 2023 (application/pdf)

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