Mental Models of the Stock Market. Seminar

Department: Finance

Speaker: Peter Andre (Goethe University)

Room: T036

Mental Models of the Stock Market
Peter Andre, Philipp Schirmer, Johannes Wohlfart

March 28, 2024

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, house-
holds 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.