Heterogeneous Beliefs, Speculation, and the Equity Premium

Abstract

Agents with heterogeneous beliefs about fundamental growth do not share risks perfectly but instead speculate with each other on the relative accuracy of their models' predictions. They face the risk that market prices move more in line with the trading models of competing agents than with their own. Less risk-averse agents speculate more aggressively and demand higher risk premiums. My calibrated model generates countercyclical consumption volatility, earnings forecast dispersion, and cross-sectional consumption dispersion. With a risk aversion coefficient less than one, agents' speculation causes half the observed equity premium and lowers the riskless rate by about 1%. Copyright 2008 by The American Finance Association.

Belief Dispersion in the Stock Market

“…Each distinct θ‐type investor chooses an admissible portfolio strategy , the fraction of wealth invested in the stock, so as to maximize her CRRA preferences over the horizon value of her portfolio , where denotes the expectation under the θ‐type investor's subjective beliefs and the financial wealth of the θ‐type investor follows In this setting investors' preferences are over the horizon value of their wealth/consumption rather than over intermediate consumption, which would otherwise endogenize the interest rate in equilibrium. As the previous literature highlights, the presence of belief heterogeneity may affect the interest rate in the economy (e.g., Detemple and Murthy (), David ()). However, in this paper our focus is not on the interest rate but rather on the marginal effects of belief dispersion on risky stocks.…”

“…Differently from these works, we show that the dispersion‐mean return relation is negative when the view on the stock is relatively optimistic and positive otherwise. Moreover, in this literature, David () shows that belief heterogeneity leads to a nonmonotonic relation between the mean return and investors' risk aversion. We complement David () by providing the additional insight that the relation between the mean return and risk aversion depends on the level of optimism/pessimism about the stock—it is nonmonotonic when the view is relatively pessimistic but is monotonic otherwise.…”

Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility

“…12 12 David (2008) says that the fluctuating difference of measure between the two groups makes the market “effectively incomplete.” That is a matter of semantics. Analytically, the equilibrium can be obtained by complete‐market methods.…”

Six Impossible Things Before Breakfast

“…Across the mainstream academic enterprise, the most telling indicator of the obsolescence of the hypotheses of “efficient markets and rational expectations” has been the supplanting of the canonical efficient and rational “representative agent” by heterogeneous agents whose dynamic interactions drive market behaviour that actually resembles the markets we observe. Hong and Stein 16 argue for what they explicitly term “Disagreement Models” (see also Hong, Scheinkman and Xiong 17 ): the Journal of Finance itself has become increasingly open to articles such as David's “Heterogeneous Beliefs, Speculation, and the Equity Premium” 18 and similar works from Caballero and Krishnamurthy 19 and Bernhardt and Taub 20 . These scholars and many others are defining a world of financial economics embedded in institutions that have evolved historically and that represent necessarily inadequate efforts to model Knights “brute fact” of inevitable uncertainty.…”