Asset pricing with cognitive dissonance

The behavior of asset prices is analyzed in a general equilibrium model where agents not only have preferences over consumption but also (implicitly) over their beliefs. Agents endogenously choose to disregard information contained in a signal if it conflicts with their desired beliefs. In this way, systematic overvaluation and undervaluation of shares arise, as well as regions of excessive price volatility and regions of excessive price stability. We find that the distortion of the asset pricing process is closely related to the precision of the information provided by the signal. The latter result might contribute to an understanding of the genesis of sunspots which occur in the limit when the signal becomes completely uninformative.