Asset Pricing in a World of Imperfect Foresight

A key assumption of dynamic asset pricing theory is that agents have perfect foresight: for all future contingencies, they correctly foresee the corresponding equilibrium prices. Is it possible for prices to still reflect perfect foresight even if agents have imperfect foresight? We answer affirmatively, provided agents exhibit a mild form of narrow framing, which we refer to as dynamic narrow framing: while accounting for future endowments, agents ignore re-trading opportunities. This behaviour vastly simplifies the computation of optimal choices because it obviates the need to form beliefs about future prices. Obviously, choices will generally be different, and hence, sub-optimal, compared to those that are obtained if agents were to optimize dynamically using perfect foresight about future prices. With a controlled experiment, we verify that our behavioural assumption explains both prices and choices. Our findings allow us to re-interpret the successes (when evaluating prices only) and failures (when evaluating prices against choices) of traditional tests of asset pricing theory on historical data from the field.