Does Belief Heterogeneity Explain Asset Prices: The Case of the Longshot Bias

This paper studies belief heterogeneity in a benchmark competitive asset market: a market for Arrow-Debreu securities. We show that differences in agents’ beliefs lead to a systematic pricing pattern, the favorite longshot bias (FLB): securities with a low payout probability are overpriced while securities with high probability payout are underpriced. We apply demand estimation techniques to betting market data, and find that the observed FLB is explained by a two-type population consisting of canonical traders, who hold virtually correct beliefs and are the majority type in the population (70%); and noise traders exhibiting significant belief dispersion. Furthermore, exploiting variation in public information across markets in our dataset, we show that our belief heterogeneity model empirically outperforms existing preference based explanations of the FLB. JEL Classification: C13, C51, D40, G13, L00.