Cognitive biases, ambiguity aversion and asset pricing in financial markets

We present a new theory of asset pricing and portfolio choices under asymmetric reasoning, contrast the predictions with those under asymmetric information, and present experimental evidence in favor of our theory. The Efficient Markets Hypothesis and its formal foundation, the Rational Expectations Equilibrium, predict that asymmetric information is irrelevant because prices correctly aggregate all available information. We argue here that asymmetric reasoning is fundamentally different: prices may not reflect all (types of) reasoning because (some) agents who observe prices that cannot be reconciled with their reasoning drop their reasoning while notgiving prices the benefit of the doubt, and hence become sufficiently ambiguity averse so that they no longer directly influence prices. We present the results from an experiment, where, through manipulation of aggregate risk, we separately test the price and choice implications of our theory. Consistent with our theory, we find that i) a significant fraction of our subjects become price-insensitive, that ii) mispricing decreases as the fraction of price-sensitive agents increases when there is no aggregate risk, and iii) price-insensitive agents tend to trade to more balanced portfolios when there is aggregate risk