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Motivated by the insight of Keynes (1936) on the importance of higher order beliefs in financial markets, we examine the role of such beliefs in generating drift in asset prices.We show that in a model in which agents have heterogeneous priors and are uncertain about the beliefs of others, differences in higher order beliefs may lead to price drift. Such drift does not arise in the classical difference of opinion paradigm, in which others' beliefs are common knowledge. We also argue that price drift does not result from aggregation of heterogeneous beliefs in a rational expectation equilibrium, in contrast to previous literature.

The empirical evidence on investor disagreement and trading volume is difficult to reconcile in standard rational expectations models. We develop a dynamic model in which investors disagree about the interpretation of public information. We obtain a closed-form linear equilibrium that allows us to study which restrictions on the disagreement process yield empirically observed volume and return dynamics. We show that when investors have infrequent but major disagreements, there is positive autocorrelation in volume and positive correlation between volume and volatility. We also derive novel empirical predictions that relate the degree and frequency of disagreement to volume and volatility dynamics. Copyright (c) 2010 the American Finance Association.

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