Mental Models of the Stock Market

Peter Andre, Philipp Schirmer and Johannes Wohlfart

No 10691, CESifo Working Paper Series from CESifo

Abstract: Investors’ return expectations are pivotal in stock markets, but the reasoning behind these expectations is not well understood. 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, academic experts refer to market efficiency to explain their forecasts, whereas households and many professionals directly equate higher future earnings with higher future returns, neglecting the offsetting effects 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 or ignorance about how returns are calculated. Instead, it reflects a gap in respondents’ mental models: they are unfamiliar with the concept of equilibrium pricing. Lastly, we illustrate the potential consequences of neglecting equilibrium pricing. We use panel data on household expectations to show that this neglect predicts previously documented belief anomalies such as return extrapolation and pro-cyclicality.

Keywords: mental models; return expectations (search for similar items in EconPapers)
JEL-codes: D83 D84 G11 G12 G41 G51 G53 (search for similar items in EconPapers)
Date: 2023
New Economics Papers: this item is included in nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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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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