Biased Beliefs, Asset Prices, and Investment: A Structural Approach

We structurally estimate a model in which agents’ information processing biases can cause predictability in firms’ asset returns and investment inefficiencies. We generalize the neoclassical investment model by allowing for two biases–overconfidence and overextrapolation of trends–that distort agents’ expectations of firm productivity. Our model's predictions closely match empirical data on asset pricing and firm behavior. The estimated bias parameters are well identified and exhibit plausible magnitudes. Alternative models without either bias or with efficient investment fail to match observed return predictability and firm behavior. These results suggest that biases affect firm behavior, which in turn affects return anomalies.