Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

Abstract

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as he persistence and predictability of excess returns found in the data.

Diverse Beliefs, Survival and the Market Price of Risk

“…Consumption growth was sharply negative during 1930-3 and, with a short training sample, this experience would have made a Bayesian pessimistic about the onset and persistence of contractions. Thus, F hh is lower and F ll is higher than the estimates of Cecchetti et al (2000).…”

“…We calibrate F from estimates reported by Cecchetti et al (2000) who estimated a hidden Markov model for aggregate consumption growth,…”

Ambiguity, Risk, and Asset Returns in Continuous Time

“…For (i), consider the alternative deviation from rational expectations modeling whereby we continue to assume probabilistic sophistication (a single prior) but relax the rational expectations hypothesis that the agent knows the true probability law. This approach is adopted in Abel (2002) and Cecchetti, Lam, and Mark (2000) in order to address the equity premium puzzle. Our model ultimately delivers a 'distorted probability measure,' selected endogenously from the agent's set of priors, that would deliver the identical representative agent equilibrium were it adopted as a primitive specification of beliefs.…”

Rational and Near‐Rational Bubbles Without Drift

“…The near-rational asset pricing solution developed here is related to a large body of research that seeks to explain stock market behaviour using some type of distorted belief mechanism or misspecified forecast rule in a representative agent framework. Examples along these lines include Barsky and Delong (1993), Timmerman (1996), Barberis et al (1998), Cecchetti et al (2000), Abel (2002), Lansing (2006), Branch and Evans (2010 and Bullard et al (2010), among others. Bubble models that involve the interaction of rational and non-rational agents in the same economy include Delong et al (1990), Brock and Hommes (1998), Abreu and Brunnermeier (2003) and Scheinkman and Xiong (2003).…”