Speculating on Higher-Order Beliefs

Abstract

Higher-order beliefs—beliefs about others’ beliefs—may be important for trading behavior and asset prices but have received little systematic empirical examination. Examining more than 20 years of evidence from the Robert Shiller Investor Confidence surveys, we find that investors’ higher-order beliefs provide substantial motivations for nonfundamental speculation—taking a stock market position that conflicts with one’s valuation of the market. To explore the equilibrium implications, we construct a model that matches the survey evidence and highlights that investors’ higher-order beliefs amplify stock market overreaction and excess volatility.