Probability distortion, asset prices, and economic growth

authored by

Maik Dierkes, Stephan Germer, Vulnet Sejdiu

Abstract

In this paper, we link stock market investors’ probability distortion to future economic growth. The empirical challenge is to quantify the optimality of today's decision making to test for its impact on future economic growth. Fortunately, risk preferences can be estimated from stock markets. Using monthly aggregate stock prices from 1926 to 2015, we estimate risk preferences via an asset pricing model with Cumulative Prospect Theory (CPT) agents and distill a recently proposed probability distortion index. This index negatively predicts GDP growth in-sample and out-of-sample. Predictability is stronger and more reliable over longer horizons. Our results suggest that distorted asset prices may lead to significant welfare losses.

Organisation(s)

Institute of Banking and Finance

Type

Article

Journal

Journal of Behavioral and Experimental Economics

Volume

84

ISSN

2214-8043

Publication date

02.2020

Publication status

Published

Peer reviewed

Yes

ASJC Scopus subject areas

Applied Psychology, Economics and Econometrics

Research Area (based on ÖFOS 2012)

Public finance

Sustainable Development Goals

SDG 8 - Decent Work and Economic Growth

Electronic version(s)

https://doi.org/10.1016/j.socec.2019.101476 (Access: Closed)