Counterfactual Thinking, Trading, and Market Inefficiency

Abstract

This study examines the effects of counterfactual thinking on asset pricing and market efficiency in a noisy rational expectation model. Emotional traders with counterfactual thinking trade an equity with informed and uninformed rational traders. An equilibrium exists wherein shocks to emotional traders’ counterfactuals are aggregated and are incorporated into equity price. Counterfactual thinking reduces the informational efficiency of the equity market. The stronger traders’ counterfactual thinking, or the noisier the shocks to counterfactuals are, the lower the price informativeness. Counterfactual thinking also reduces price responsiveness and market liquidity.