Erik Eyster

An Approach to Asset Pricing Under Incomplete and Diverse Perceptions

We model a dynamic, competitive market, where in every period, risk-neutral traders trade a one-period bond against an infinitely lived asset, with limited short-selling of the long-term asset. Traders lack structural knowledge and use different “incomplete theories,” all of which give statistically correct beliefs about next periods market price of the long-term asset. The more theories there are in the market, the higher is the equilibrium price of the long-term asset. Investors with more complete theories do not necessarily earn higher returns than those with less complete ones, who can earn above the risk-free rate. We provide two necessary conditions for a trader to earn above the risk-free rate.

Preferences for Fair Prices, Cursed Inferences, and the Nonneutrality of Money

This paper explains the nonneutrality of money from two assumptions: (1) consumers dislike paying prices that exceed some fair markup on firms’ marginal costs; and (2) consumers under infer marginal costs from available information. After an increase in money supply, consumers underappreciate the increase in nominal marginal costs and hence partially misattribute higher prices to higher markups; they perceive transactions as less fair, which increases the price elasticity of their demand for goods; firms respond by reducing markups; in equilibrium, output increases. By raising perceived markups, increased money supply inflicts a psychological cost on consumers that can offset the benefit of increased output.

Correlation Neglect in Portfolio Choice: Lab Evidence

Optimal portfolio theory depends upon a sophisticated understanding of the correlation among financial assets. In this paper, we examine people’s understanding of correlation using portfolio-allocation problems and find it to be strongly imperfect. Our experiment uses pairs of problems having the same span of assets — identical sets of attainable returns — but different correlations between assets. While expected-utility theory makes the same prediction across paired problems, subjects behave very differently within pairs. We find evidence for correlation neglect — treating correlated variables as uncorrelated — as well as for the “1/n heuristic” — investing half of wealth each of the two available assets.