NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Social Cost of Near-Rational Investment

Tarek A. Hassan, Thomas M. Mertens

NBER Working Paper No. 17027
Issued in May 2011
NBER Program(s):   AP   EFG

We show that the stock market may fail to aggregate information even if it appears to be efficient and that the resulting decrease in the information content of stock prices may drastically reduce welfare. We solve a macroeconomic model in which information about fundamentals is dispersed and households make small, correlated errors when forming expectations about future productivity. As information aggregates in the market, these errors amplify and crowd out the information content of stock prices. When stock prices reflect less information, the conditional variance of stock returns rises. This increase in financial risk distorts the long-run level of capital accumulation, and causes costly (first-order) distortions in the long-run level of consumption.

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This paper was revised on May 21, 2014

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Document Object Identifier (DOI): 10.3386/w17027

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