Do Behavioral Biases Adversely A¤ect theMacro-Economy?

This study investigates whether the adverse e¤ects of investors’behavioral biases extend beyond the domain of …nancial markets to the broad macro-economy. We focus on the risk sharing (or income smoothing) role of …nancial markets and demonstrate that risk sharing levels are higher in U.S. states in which investors have higher cognitive abilities and exhibit weaker behavioral biases. Further, states with better risk sharing opportunities achieve higher levels of risk sharing if investors in those states exhibit greater …nancial sophistication. Among the various determinants of risk sharing, behavioral factors have the strongest e¤ects. The average level of risk sharing in states with unsophisticated investors (= 0.121) is less than half of the average risk sharing level in states with …nancially sophisticated investors (= 0.308). Collectively, our evidence indicates that the high risk sharing potential of …nancial markets is not fully realized because the aggregate behavioral biases of individual investors impede state-level risk sharing. Keywords: Risk sharing, income risk, …nancial markets, cognitive abilities, behavioral biases, investor sophistication. JEL: E10, G11, G12. Current version: September 15, 2008. Please address all correspondence to Alok Kumar, Department of Finance, McCombs School of Business, University of Texas at Austin, 1 University Station, B6600, Austin, TX 78712; Phone: 512-232-6824 ; email: [email protected]. George Korniotis is at the Board of Governors of the Federal Reserve System; Phone: 202-452-2581; email: [email protected]. We thank Ben Bernanke, Michael Brandt, John Campbell, Sean Campbell, John Cochrane, Jonathan Cohn, George Constantinides, Joshua Coval, John Driscoll, Xavier Gabaix, Erik Heit…eld, John Gri¢ n, David Hirshleifer, Ramesh Rao, Bob Shiller, Sophie Shive, Bent Sorensen, and Sheridan Titman for helpful discussions and valuable comments. We also thank Bob Shiller for the state-level stock market wealth data and Bent Sorensen for providing several data sets, including the state income data. We are responsible for all remaining errors and omissions. The analysis and conclusions set forth are those of the authors and should not be taken to indicate any endorsement by the research sta¤ or the Board of Governors. Behavioral Biases and the Macro-Economy 1. Introduction One of the major challenges for the …eld of behavioral …nance is to convincingly establish that investors’behavioral biases have aggregate market-wide e¤ects (e.g., Shleifer (2000), Hirshleifer (2001), Barberis and Thaler (2003)). The recent behavioral asset pricing literature demonstrates that the aggregate forces generated by investors’ systematic behavioral biases have the ability to in‡uence stock prices and trading volume (e.g., Odean (1998), Barberis, Huang, and Santos (2001), Coval and Shumway (2005), Grinblatt and Han (2005), Statman, Thorley, and Vorkink (2006), Barberis and Huang (2008)). At a more aggregate level, behavioral mechanisms can generate high levels of market risk premium and even induce market-level misvaluations that could create a “bubble”(e.g., Benartzi and Thaler (1995), Scheinkman and Xiong (2003)). In this paper, we develop these insights further and examine whether the systematic e¤ects of behavioral biases extend beyond the domain of …nancial markets to the aggregate macro-economy. Speci…cally, we investigate whether behavioral frictions adversely a¤ect state-level income risk sharing (i.e., state-level income smoothing) that can be achieved using …nancial markets.1 To our knowledge, this is the …rst paper that examines whether systematic behavioral biases can in‡uence broader macro-economic phenomena such as state-level risk sharing. We focus on income smoothing for two reasons. First, this is a natural setting to examine whether the adverse e¤ects of behavioral biases in people’s investment decisions have far-reaching e¤ects. One of the fundamental roles of …nancial markets is to enhance the ability of an economy to reduce idiosyncratic income risk by facilitating the cross-ownership of productive assets. Thus, if the e¤ects of distortions in …nancial decisions induced by behavioral biases ripple beyond …nancial markets, they are likely to be re‡ected in state-level income smoothing estimates. Second, through its direct e¤ect on consumption smoothing, income smoothing has the potential to considerably a¤ect asset prices, expected returns, and the level of social welfare. The interstate risk sharing literature reports that at the aggregate-level only 35-39% of statespeci…c, idiosyncratic income risk can be eliminated through the …nancial markets channel (e.g., Asdrubali, Sorensen, and Yosha (1996), Athanasoulis and Van Wincoop (2001)). These estimates are surprisingly low because …nancial assets contain information about future economic activities (e.g., Harvey (1988), Barro (1990), Bernanke and Blinder (1992)) and have the potential to facilitate high levels of risk sharing, both within the U.S. and across countries (e.g., Brandt, Cochrane, and Santa-Clara (2006)). These aggregate-level risk sharing estimates, however, mask the substantial cross-sectional het1 Income smoothing is distinct from consumption smoothing (or total risk sharing), which is measured by comparing the growth rates of GSP and state-level consumption (e.g, Cochrane (1991), Asdrubali, Sorensen, and Yosha (1996)). The total risk sharing measure captures the level of risk sharing that is achieved through …nancial markets and other channels, including unemployment insurance, federal taxation, and …scal policies.