Abstract: The “limited participation puzzle" is the robust empirical finding that substantially fewer people participate in the stock market than predicted by standard models. Recent evidence suggests subjective returns play a key role in stock market participation. Furthermore, there is strong evidence that stock market experiences, i.e. realized returns, impact subjective returns. I bring a model into the laboratory and find that experience-based subjective returns can explain limited participation. Stock market participation is increasing in both subjective returns and past realized returns. I find micro-evidence that “learning from experience" generates heterogeneity in subjective returns, where subjects who experience low returns have lower subjective returns than subjects who experience high returns. In particular, subjects over-weigh the price trend when experiencing low returns and are more likely to believe that prices are trending downward when they receive a low return.
Abstract: A simple asset pricing model with endogenous participation and subjective risk can explain both the negative cross-country correlation between participation rates and the volatility of excess returns along with the time-varying participation rates in the data. Belief-driven learning dynamics are key to explaining the interplay between participation, subjective risk, and price volatility. When agents adaptively learn about the risk and return, the model can generate 25% of the excess volatility in stock prices observed in U.S. data while matching key moments. With learning about risk, excess volatility of prices is driven by fluctuations in the participation rate that arise because agents' risk estimates vary with prices. I find that learning about risk is quantitatively more important than learning about returns.
Learning, Hypothesis Testing, and Restricted Perceptions Equilibria in progress