research
WORKING PAPERS:
Diagnostic Expectations and Stock Returns (with N. Gennaioli, R. La Porta and A. Shleifer), September 2017.
Abstract: We revisit La Porta’s (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks with the most pessimistic forecasts. We document that this finding still holds, and present several further facts about the joint dynamics of fundamentals, expectations, and returns for these portfolios. We explain these facts using a new model of belief formation based on a portable formalization of the representativeness heuristic. In this model, analysts forecast future fundamentals from the history of earnings growth, but they over-react to news by exaggerating the probability of states that have become objectively more likely. Intuitively, fast earnings growth predicts future Googles but not as many as analysts believe. We test predictions that distinguish this mechanism from both Bayesian learning and adaptive expectations, and find supportive evidence. A calibration of the model offers a satisfactory account of the key patterns in fundamentals, expectations, and returns.
Memory, Attention and Choice (with N. Gennaioli and A. Shleifer), February 2017.
Abstract: We present a theory of consumer choice that combines elements of limited recall and of allocation of attention distorted by salience. The theory helps clarify and organize a variety of evidence dealing with consumer reaction to information, including surprises in quality and prices, unshrouding of hidden attributes such as taxes or maintenance costs, and reminders. A common feature of the empirical evidence, which our model sheds light on but standard models do not explain, is that consumers under or overreact to information, depending on what draws their attention. We also present a normative analysis of reaction to reminders which adjusts the more standard "sufficient statistic" methodology.
PUBLICATIONS:
Beliefs about Gender (with K. Coffman, N. Gennaioli and A. Shleifer)
American Economic Review, forthcoming.
Abstract: We conduct a laboratory experiment on the determinants of beliefs about own and others’ ability across different domains. A preliminary look at the data points to two distinct forces: miscalibration in estimating performance depending on the difficulty of tasks and gender stereotypes. We develop a theoretical model that separates these forces and apply it to analyze a large laboratory dataset in which participants estimate their own and a partner’s performance on questions across six subjects: arts and literature, emotion recognition, business, verbal reasoning, mathematics, and sports. We find that participants greatly overestimate not only their own ability but also that of others, suggesting that miscalibration is a substantial, first order factor in stated beliefs. Women are better calibrated than men, providing more accurate estimates of ability both for themselves and for others. Gender stereotypes also have strong predictive power for beliefs, particularly for men’s beliefs about themselves and others’ beliefs about the ability of men. Our findings help interpret evidence on gender gaps in self-confidence.
Diagnostic Expectations and Credit Cycles (with N. Gennaioli and A. Shleifer)
Journal of Finance, forthcoming.
Abstract: We present a model of credit cycles arising from diagnostic expectations – a belief formation mechanism based on Kahneman and Tversky’s (1972) representativeness heuristic. Diagnostic expectations overweight future outcomes that become more likely in light of incoming data. The expectations formation rule is forward looking and depends on the underlying stochastic process, thus being immune to the Lucas critique. Diagnostic expectations reconcile extrapolation and neglect of risk in a unified framework. In our model, credit spreads are excessively volatile, over-react to news, and are subject to predictable reversals. These dynamics can account for several features of credit cycles and macroeconomic volatility.
Stereotypes (with K. Coffman, N. Gennaioli and A. Shleifer)
Quarterly Journal of Economics, November 2016.
Abstract: We present a model of stereotypes based on Kahneman and Tversky's representativeness heuristic. A decision maker assesses a target group by overweighting its representative types, defined as the types that occur more frequently in that group than in a baseline reference group. Stereotypes formed in this way contain a "kernel of truth"" they are rooted in true differences between groups. Because stereotypes focus on differences, they cause belief distortions, particularly when groups are similar. Stereotypes are also context dependent: beliefs about a group depend on the characteristics of the reference group. In line with our predictions, beliefs in the lab about abstract groups and beliefs in the field about political groups are context dependent and distorted in the direction of representative types.[Online Appendix]
Competition for Attention (with N. Gennaioli and A. Shleifer)
Review of Economic Studies, April 2016.
Abstract: We present a model of market competition and product differentiation in which consumers' attention is drawn to the products' most salient attributes. Firms compete for consumer attention via their choices of quality and price. Strategic positioning of each product affects how all other products are perceived. With this attention externality, depending on the cost of producing quality some markets exhibit "commoditized" price salient equilibria, while others exhibit "de-commoditized" quality salient equilibria. When the costs of quality change, innovation can lead to radical shifts in markets, as in the case of decommoditization of the coffee market by Starbucks. In the context of financial innovation, the model generates the phenomenon of "reaching for yield". [Online Appendix]
Salience Theory of Judicial Decisions (with N. Gennaioli and A. Shleifer)
Journal of Legal Studies, January 2015.
Abstract: We present a model of judicial decision making in which the judge overweights the salient facts of the case. The context of the judicial decision, which is comparative by nature, shapes which aspects of the case stand out and draw the judge's attention. By focusing judicial attention on such salient aspects of the case, legally irrelevant information can affect judicial decisions. Our model accounts for a range of recent experimental evidence bearing on the psychology of judicial decisions, including anchoring effects in the setting of damages, decoy effects in choice of legal remedies, and framing effects in the decision to litigate. The model also offers a new approach to positive analysis of damage awards in torts.
Salience and Consumer Choice (with N. Gennaioli and A. Shleifer)
Journal of Political Economy, October 2013.
Abstract: We present a theory of context-dependent choice in which a consumer’s attention is drawn to salient attributes of goods, such as quality or price. An attribute is salient for a good when it stands out among the good’s attributes, relative to that attribute’s average level in the choice set (or more broadly, the choice context). Consumers attach disproportionately high weight to salient attributes and their choices are tilted toward goods with higher quality/price ratios. The model accounts for a variety of disparate evidence, including decoy effects and context-dependent willingness to pay. It also suggests a novel theory of misleading sales. [Online Appendix]
Salience and Asset Prices (with N. Gennaioli and A. Shleifer)
American Economic Review, Papers & Proceedings, May 2013.
Abstract: We present a simple model of asset pricing in which payoff salience drives investors' demand for risky assets. The key implication is that extreme payoffs receive disproportionate weight in the market valuation of assets. The model accounts for several puzzles in finance in an intuitive way, including preference for assets with a chance of very high payoffs, an aggregate equity premium, and countercyclical variation in stock market returns.
Salience Theory of Choice under Risk (with N. Gennaioli and A. Shleifer)
Quarterly Journal of Economics, May 2012
Abstract: We present a theory of choice among lotteries in which the decision maker’s attention is drawn to (precisely defined) salient payoffs. This leads the decision maker to a context-dependent representation of lotteries in which true probabilities are replaced by decision weights distorted in favor of salient payoffs. By specifying decision weights as a function of payoffs, our model provides a novel and unified account of many empirical phenomena, including frequent risk-seeking behavior, invariance failures such as the Allais paradox, and preference reversals. It also yields new predictions, including some that distinguish it from prospect theory, which we test. [Online Appendix]
Salience and Experimental Tests of the Endowment Effect (with N. Gennaioli and A. Shleifer)
American Economic Review, Papers & Proceedings, May 2012
Abstract: We provide a novel account of experimental evidence for the endowment effect using the salience mechanism (Bordalo, Gennaioli, and Shleifer, 2011). The two-stage procedure implemented in experiments implies that the endowed good and other goods are evaluated in different contexts. We describe conditions under which this leads to the standard effect, but also account for recent evidence such as a reverse endowment effect for bads and a role for reference prices in modulating the WTA-WTP gap.