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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.

Keywords: Risk sharing, income risk, financial markets, cognitive abilities, behavioral biases, investor sophistication

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