Cognitive Biases, Ambiguity Aversion and Asset Pricing in Financial Markets∗

The behavior of agents in financial markets often displays biases or errors; for example, agents frequently do not compute probabilities correctly. However, we argue that these biases/errors are not always reflected in prices. In particular, we hypothesize that agents who make errors in computing probabilities lose confidence in their probability estimates when they face market prices that are inconsistent with their calculations; they then perceive (relevant) uncertain events as ambiguous (rather than risky), and hedge against this perceived ambiguity by holding a portfolio that generates unambiguous returns. These agents are price insensitive – they do not adjust their portfolio with changes in prices – and do not (directly) influence market prices. We identify price insensitive agents in an asset market experiment, and we test implications of our hypothesis: (i) agents who do not update correctly hold more balanced portfolios; (ii) the difference between portfolio holdings of agents who do not update correctly and agents who do update correctly increases as aggregate risk in the economy increases; (iii) prices are determined by the behavior of agents who do update correctly. Our experiments confirm all these hypotheses, but the extent to which observed prices conform to theoretical predictions decreases as the number of agents who do not update correctly increases. These observations reinforce our view that market prices trigger behavior that is consistent with ambiguity aversion. JEL Classification: G11, G12, G14