N°24-66: Distorted Beliefs and Asset Prices

We investigate the role of distorted beliefs in the stock market, particularly their impact on risk premia. We identify the bias in investors' expectations stemming from belief distortions and decompose the predictable component of market returns into investors' beliefs about future returns and their bias. We then show that shocks to this bias, because it manifests itself as discount-rate risk in the data but represents cash-flow risk from investors' perspective, emerges as a priced risk factor. Our findings indicate that distorted beliefs impact both the time series and cross-section of expected returns, helping to explain observed deviations from theoretical predictions under rational expectations.