Jessica Wachter

James Paron, Michael Kahana, Jessica Wachter, Associative Learning and Representativeness.

Abstract: The representativeness heuristic constitutes a striking departure from Bayesian updating. According to a strong form of the heuristic, agents reverse a conditioning argument: for example inferring that a patient is more likely than not to have a rare disease, conditional on a positive test result. The correct inference is that a positive test result is more likely than not, conditional on disease. Recent research implicates representativeness in a wide range of financial market anomalies, with potential consequences for the real economy. However, the cognitive foundations of the representativeness heuristic (RH) remain unknown. Here, we show that the RH emerges from a theory of associative memory and recognition, leading to a cognitive foundation for the RH, and a means of integrating the RH into economic models involving decision-making under uncertainty.

Jules van Binsbergen, Sophia Hua, Jonas Peeters, Jessica Wachter, Is the United States a lucky survivor? A hierarchical Bayesian approach.

Hongye Guo and Jessica Wachter (2024), “Superstitious” Investors, .

Jessica Wachter and Yicheng Zhu (Work In Progress), Learning with rare disasters.

Abstract: Financial crises appear to have long-lasting effects, even after the crisis itself has past. This paper offers a simple explanation through Bayesian learning from rare events. Agents face a latent and time-varying probability of economic disaster. When a disaster occurs, learning results in greater effects on asset prices because agents update their probability of future disasters. Moreover, agents' belief that the disaster risk is high can rationally persist for years, even when it is in fact low. We generalize the model to allow for a noisy signal of the disaster probability. This generalized model explains excess stock market volatility together with negative skewness, effects that previous models in the literature struggle to explain.

Ulrike Malmendier and Jessica Wachter, “Memory of Past Experiences and Economic Decisions”. In Oxford Handbook of Human Memory, edited by Michael Kahana Anthony Wagner, (Oxford University Press, 2024)

Abstract: In traditional economic models, memories of past experiences affect choices only to the extent that they represent information. We review recent advances in economic research that have introduced a role for long-lasting effects of personal past experiences and the memory thereof into economics. We first document the empirical evidence on long-lasting experience effects in finance and economics. We then discuss the main approaches the literature has taken in incorporating psychological theories of long-lasting memories into economics. Our treatment suggests a role for models of memory in accounting not only for micro-level phenomena, but for anomalies within asset pricing and macroeconomics more broadly.

Mehran Ebrahimian and Jessica Wachter (2024), Risks to Human Capital, .

Abstract: Do financing constraints deepen recessions? To help answer this question, we build a model with inalienable human capital, in which investors finance individuals who can potentially become skilled. Though investment in skill is always optimal, it does not take place in some states of the world, due to moral hazard. In intermediate states of the world, individuals acquire skill; however outside investors and individuals inefficiently share risk. We show that this simple moral hazard problem, combined with risk aversion of individuals and outside investors, amplifies the equity premium, lowers the riskfree rate, and leads to disaster states that fall especially heavily on some agents but not on others. We show that the possibility of disaster states distorts risk prices, even under calibrations in which they never occur in equilibrium.

Jessica Wachter and Michael Kahana (2024), A retrieved-context theory of financial decisions, Quarterly Journal of Economics, 139 (2), pp. 1095-1147.

Abstract: Studies of human memory indicate that features of an event evoke memories of prior associated contextual states, which in turn become associated with the current event's features. This retrieved-context mechanism allows the remote past to influence the present, even as agents gradually update their beliefs about their environment. We apply a version of retrieved context theory, drawn from the literature on human memory, to explain three types of evidence in the financial economics literature: the role  of early life experience in shaping investment choices, occurrence of financial crises, and the impact of fear on asset allocation. These applications suggest a recasting of neoclassical rational expectations in terms of beliefs as governed by principles of human memory.

Joao F. Gomes, Marco Grotteria, Jessica Wachter (2023), Foreseen Risks, Journal of Economic Theory, 212 ().

Abstract: Financial crises tend to follow rapid credit expansions. Causality, however, is far from obvious. We show how this pattern arises naturally when financial intermediaries optimally exploit economic rents that drive their franchise value. As this franchise value varies over the business cycle, so too do the incentives to engage in risky lending. The model leads to novel insights on the effects of recent unconventional monetary policies in developed economies. We argue that bank lending might have responded less than expected to these interventions because they enhanced franchise value, inadvertently encouraging banks to pursue safer investments in low-risk government securities.

Jessica Wachter and Yicheng Zhu (2022), A Model of Two Days: Discrete News and Asset Prices, Review of Financial Studies, 35 (5), pp. 2246-2307.

Abstract: Empirical studies demonstrate striking patterns in stock returns related to scheduled macroeconomic announcements. A large proportion of the total equity premium is realized on days with macroeconomic announcements. The relation between market betas and expected returns is far stronger on announcement days as compared with nonannouncement days. Finally, these results hold for fixed-income investments as well as for stocks. We present a model in which agents learn the probability of an adverse economic state on announcement days. We show that the model quantitatively accounts for the empirical findings. Evidence from options data provides support for the model’s mechanism.

Sangmin Oh and Jessica Wachter (2022), Cross-sectional Skewness, Review of Asset Pricing Studies, 12 (1), pp. 155-198.