Exploring the Microfoundations of Investors’ Beliefs

• Applicant: Dr. Pascal Kieren
• Subject Area: Economic Policy, Applied Economics
• Term: since 2024
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 544579747

Most of our financial decisions are made without definite knowledge of their consequences. The decisions to invest in the stock market, or to save for retirement, are commonly made without knowing in advance whether the market will go up or how much we need to save. But what determines how people form expectations about the probability of uncertain events? Most of the traditional work in financial economics assumes that people hold rational expectations which they update according to Bayes’ rule. Over the past decades, however, research has uncovered many biases in individuals’ judgement, i.e., instances in which agents’ belief updating systematically deviates from the Bayesian model. Despite early calls for empirical work on the microfoundations of biases (Fudenberg, 2006), the underlying mechanisms are still inconclusively understood. With this research proposal, we aim to contribute to a deeper understanding of the mechanisms and microfoundations of investors’ expectations. In our first project, we study the influence of reference-points on the formation of expectations. Although it is long acknowledged that reference-points influence behavior, their influence on expectations has not been studied thus far. We conjecture that reference-points are a promising candidate to jointly rationalize a collection of thus far unconnected biases in individuals’ belief formation process that have been documented across different fields and contexts. In our second project, we investigate the influence of reference-points on expectations in a setting in which they arguably matter most: the formation of portfolio expectations. Although portfolios are an important component of investor behavior, it is unclear whether portfolio return expectations simply represent the weighted average of individual asset expectations or whether they are overly influenced by the relative performance of stocks that constitute the portfolio. Finally, in our third working project we turn to the dynamics of investors’ expectations. We analyze whether information that arrives continuously in small amounts leads to the same expectations when compared to the same information that arrives in large amounts at discrete timepoints. As such, while the first two projects study the influence of reference points in the cross-section of expectations, the third project considers a case where reference points may influence the formation of expectations over time. Overall, this proposal aims to uncover unified patterns in expectations which are able to synthesize a wider range of biases in investors’ expectations. On the one hand, the data resulting from this proposal can be used to develop and discipline parsimonious models of economic choice that can capture many features of behavior with a smaller number of parameters. On the other hand, the insights can be used to improve consumer protection and to aid the development of financial regulation guidelines.

• DFG Programme: Research Grants