Irrationality, Asset Pricing, and Financial Intermediaries

Abstract

We model irrational investors who can impact prices to cause predictability in returns and rational investors who are wealth-constrained in their attempts to arbitrage mispricing. We show that rational investors relax wealth constraints by forming financial intermediaries which leverage the wealth of the irrational investors. Surprisingly, financial intermediation is facilitated by the learning ability of irrational investors. Irrational investors attribute the superior trading profits of rational investors to superior information. They delegate the intermediary to invest on their behalf because they think it has better information, even though the source of its trading profits is its rationality. This helps the intermediary mitigate the predictability in prices the irrational investors create in the first place, despite the fact that it possesses no informational advantage over anybody. The intermediary does not eliminate equilibrium mispricing because it strategically limits the size of its funds to maximize its profit. A large financial intermediary is shown to be more profitable than multiple small intermediaries. Empirical implications are drawn about the profitability of intermediaries, predictability in prices, and wealth transfers between rational and irrational investors.