We analyze the performance of irrational investors, who mistake expected returns of assets in a multi-asset economy. Mistakes by probabilistically unsophisticated investors that a priori seem small lead to severe underperformance compared with rational investors, under general conditions. Our results contrast with previous studies of single-asset economies, which find modest underperformance by irrational investors. In a calibration, an irrational investor who mistakes expected returns by 20% loses almost 95% of his consumption and wealth in about 25 years. The welfare cost of this underperformance is significant, about 40% of the total wealth in the economy.

We introduce a reduced-form term structure model with closed-form solutions for yields where the short rate and market prices of risk are nonlinear functions of Gaussian state variables. The nonlinear model with three factors matches the time-variation in expected excess returns and yield volatilities of US Treasury bonds from 1961 to 2014. Yields and their variances depend on only three factors, yet the model exhibits features consistent with Unspanned Risk Premia (URP) and Unspanned Stochastic Volatility (USV).