Study on "Mental Models of the Stock Market"

Investors' Misunderstanding of Market Equilibrium

Study on "Mental Models of the Stock Market": Investors' Misunderstanding of Market Equilibrium Study

An actual study on "Mental Models of the Stock Market" investigates the mental models of investors and their impact on stock return expectations. Simply put, a mental model is a representation of reality in human perception. Our memory, our perception of reality, our perception of risks and many other thought processes are based on the use of these images (so-called cognitive artifacts). In 1983, the concept and term “mental models” was coined by Princeton professor and psychologist Philip Nicholas Johnson-Laird.

The research focuses on how different economic agents, including households, retail investors, financial professionals, and academic experts, interpret and react to stale news about future earnings of companies. The study aims to uncover the reasoning behind these expectations, particularly in the context of risk management and equilibrium pricing.

The study employs surveys conducted with various groups:

  • US and German General Population: Surveys with over 2,400 US households and nearly 4,000 German households.
  • Retail Investors: Surveys with 408 US and 299 German retail investors.
  • Financial Advisors and Fund Managers: Surveys with 406 US financial advisors and 105 German fund managers.
  • Academic Experts: A survey of 116 international academic experts in financial economics.

These surveys present hypothetical scenarios about stale news (four weeks old) regarding future earnings of companies like Nike, and respondents are asked to predict future stock returns and explain their reasoning.

Key Findings

1. Inference from Stale News:

  • Academic experts largely view stale news as irrelevant for predicting future returns, consistent with the efficient market hypothesis.
  • In contrast, a significant proportion of households, retail investors, and financial advisors believe that stale positive (or negative) news leads to higher (or lower) expected future returns. This belief persists across different future horizons and both company-specific and aggregate market scenarios.

2. Mental Models and Reasoning:

  • Academic experts often cite market efficiency and risk-based asset pricing in their reasoning, emphasizing that expected returns are determined by risk properties and not stale news.
  • Many non-experts neglect equilibrium pricing and directly equate higher expected earnings with higher expected returns. This neglect of equilibrium adjustments is prevalent among households, retail investors, and financial advisors.
  • Fund managers show diverse reasoning, with some aligning with market efficiency and others neglecting equilibrium pricing.

3. Experimental Interventions:

  • Experiments with households show that neither focusing attention on trading responses and price changes nor explicitly ruling out risk-based reasoning significantly changes their return forecasts. This suggests a fundamental gap in understanding equilibrium pricing.

4. Belief Anomalies and Consequences:

  • The study links equilibrium neglect to belief anomalies such as return extrapolation and pro-cyclical expectations, where investors expect higher returns during economic booms and lower returns during recessions.
  • The neglect of equilibrium pricing leads to behavior such as over-trading and failure to adjust portfolios appropriately in response to earnings news.

Implications for Risk Management

The findings have significant implications for risk management and financial education:

  • Educational Initiatives: There is a need for targeted financial education to improve understanding of market equilibrium and risk-based asset pricing among retail investors and financial professionals.
  • Regulatory Measures: Enhancing transparency and information availability can help mitigate informational inefficiencies and improve market outcomes.
  • Investment Strategies: Financial advisors should focus on correcting clients' misperceptions about equilibrium pricing to foster more realistic return expectations and investment strategies.


The study highlights the critical role of mental models in shaping investors' return expectations and their behavior in financial markets. It reveals a substantial gap in understanding equilibrium pricing among non-experts, leading to systematic expectation errors and suboptimal investment decisions. Addressing this gap through education and improved market practices can enhance overall market efficiency and investor outcomes.

Download of the study

[ Source of cover photo: Generated with AI ]
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