Finance and Economics Discussion Series (FEDS)
October 2008
Do Behavioral Biases Adversely Affect the Macro-Economy?
George M. Korniotis and Alok Kumar
Abstract:
This study investigates whether the adverse effects of investors' behavioral biases extend beyond the domain of financial markets to the broad macro-economy. We focus on the risk sharing (or income smoothing) role of financial 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 financial sophistication. Among the various determinants of risk sharing, behavioral factors have the strongest effects. 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 financially sophisticated investors (= 0.308). Collectively, our evidence indicates that the high risk sharing potential of financial markets is not fully realized because the aggregate behavioral biases of individual investors impede state-level risk sharing.
Full paper (Screen Reader Version)Keywords: Risk sharing, income risk, financial markets, cognitive abilities, behavioral biases, investor sophistication
PDF: Full Paper
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.