Choosing to Disagree in Financial Markets

Abstract

Instead of assuming that investors exhibit rational expectations or a specific behavioral bias, we allow them to choose how to interpret the information contained in their private signals and in prices. In an otherwise standard, dispersed information model of financial markets, we show that investors who experience anticipation utility systematically choose to deviate from rational expectations. In any symmetric equilibrium, investors optimally exhibit overconfidence in their private information but dismiss the information in prices. However, when aggregate risk aversion is sufficiently low, symmetric equilibria do not exist. Instead, asymmetric equilibria arise where investors endogenously exhibit bias heterogeneity: one type ignores the information in prices, while the other chooses to overweight the price signal. Since belief choices are endogenous, our analysis sheds light on the conditions under which empirically relevant behavioral biases (e.g., overconfidence, dismissiveness) naturally arise. Finally, we characterize settings in which welfare is higher under the optimally chosen subjective beliefs than under rational expectations.