Mental Models & Stock Market Behavior

Question 1

Why study Mental Models in Stock Markets?

Answer 1

• Central role of return expectation in fin. markets
• peoples understanding of the functioning of the stock market
• Understand different investment strategies

Question 2

Mental Models of the Stock Market, Setup

Answer 2

Dissect different belief structures of individuals about the stock market
- Belief in Market efficiency
-> Stock prices always correctly reflect future dividend stream, no arbitrage in equilibrium
- Belief in mis-pricing
-> Eq can deviate from efficient pricing, over/under reaction, return predictability
- Neglect of equilibrium pricing (pay no attention to stock prices)
-> Do not understand prices

Question 3

Recap Stock returns, in equilibrium

Answer 3

• Stocks that can be expected to pay higher dividends will be more expensive
• Stocks with uncertain dividends are cheaper
• Future earnings expectations are immediately priced in and indicate no increase in returns

Question 4

Mental Models of the Stock Market, Design

Answer 4

Ask people about their return expectations from stale news. Answers are segmented to fit into either belief category

Question 5

Mental Models of the Stock Market, Results

Answer 5

Academic experts predict no higher returns from stale good news, because they are already priced in. Fund managers and retail investors predict higher returns. For retail investors this is mainly due to equilibrium neglect. Financial professionals are in disagreement.

Question 6

Implications of Equilibrium Neglect

Answer 6

Can explain belief anomalies in return expectations
- in line with pro cyclical and extrapolative beliefs
- Tend to update in the same direction as growth expectations and in the same direction as past stock market returns
-> neglect of equilibrium effect might be the driver of this

Question 7

Mental Models and real-world decisions, Setup

Answer 7

Do investors mental model affect real world decisions?
Do investors adjust mental model when confronted with conflicting information?

Question 8

Mental Models and Trading among extrapolators and mean reverters

Answer 8

Measure perceived autocorrelation of stock returns. They have to forecast their expectations based on past realizations of the stock market. Then randomly show people real return conditional on previous stock returns. (close to 0). Control group learns about unconditional average return expectations

Question 9

Mental Models and Trading among extrapolators and mean reverters, Results

Answer 9

Respondends prior beliefs are negative autocorrelation of past returns
- Treatment removes notions of return predictability
- Treatment increases net purchasing of stocks during crash among prior extrapolators
- Treatment decreases purchasing of stocks during crash among prior mean reverters.

-> Mental models are elastic to new information.