Working Paper: CEPR ID: DP13857
Authors: Ian Martin; Dimitris Papadimitriou
Abstract: We present a dynamic model featuring risk-averse investors with heterogeneous beliefs. Individual investors have stable beliefs and risk aversion, but agents who were correct in hindsight become relatively wealthy; their beliefs are overrepresented in market sentiment, so “the market” is bullish following good news and bearish following bad news. Extreme states are far more important than in a homogeneous economy. Investors understand that sentiment drives volatility up, and demand high risk premia in compensation. Moderate investors supply liquidity: they trade against market sentiment in the hope of capturing a variance risk premium created by the presence of extremists.
Keywords: heterogeneous beliefs; excess volatility; sentiment; speculation; target prices
JEL Codes: G11; G12; G13; G02; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| individual investors’ beliefs (G41) | market sentiment (G10) |
| market sentiment (G10) | market prices (P22) |
| wealth distribution shifts favorably towards optimists (D39) | market prices (P22) |
| sentiment (G41) | volatility (E32) |
| volatility (E32) | risk premia (G22) |
| extreme states in heterogeneous belief economies (D80) | market prices (P22) |
| extreme states in heterogeneous belief economies (D80) | risk premia (G22) |
| speculation (D84) | market prices (P22) |