Review of Economic Studies Vol. 82 No. 1 2015
Does Belief Heterogeneity Explain Asset Prices: The Case of the Longshot Bias
Abstract
This article studies belief heterogeneity in a benchmark competitive asset market: a market for Arrow–Debreu securities. We show that differences in agents' beliefs lead to a systematic pricing pattern, the favourite–longshot bias (FLB): securities with a low-pay-out probability are overpriced, whereas securities with high probability pay-out are underpriced. We apply demand estimation techniques to betting market data, and find that the observed FLB is explained by a two-type population consisting of canonical traders, who hold virtually correct beliefs and are the majority type in the population (70%); and noise traders exhibiting significant belief dispersion. Furthermore, exploiting variation in public information across markets in our data set, we show that our belief heterogeneity model empirically outperforms existing preference-based explanations of the FLB.
- DOI
- 10.1093/restud/rdu017
- Volume
- 82
- Issue
- 1
- Pages
- 156-186
- Language
- en
- Sources
- openalex crossref bibtex:phds-export.bib