Market Selection and Welfare in a Multi-asset Economy*

We analyze the performance of irrational investors, who mistake expected returns of assets in a multi-asset economy. Mistakes by probabilistically unsophisticated investors that a priori seem small lead to severe underperformance compared with rational investors, under general conditions. Our results contrast with previous studies of single-asset economies, which find modest underperformance by irrational investors. In a calibration, an irrational investor who mistakes expected returns by 20% loses almost 95% of his consumption and wealth in about 25 years. The welfare cost of this underperformance is significant, about 40% of the total wealth in the economy. Copyright 2013, Oxford University Press.