What You Can’t See: Contingent Thinking Failures in Dynamic Markets
People make correct inferences from observed events but make mistakes when reasoning about hypothetical events. I study the implications in competitive markets. I define Dynamic Cursed Expectations (DCE), where agents treat events occurring at different future periods as independent. I build on it to define Dynamic Cursed Expectations Equilibrium (DCEE) and prove its existence for a general financial economy. I apply DCEE to an asset pricing model and show that in DCEE agents underestimate the variance of risky assets, which under risk aversion leads to overvaluation relative to the Rational Expectations Equilibrium benchmark.