Learning from Prices and the Dispersion in Beliefs

Abstract:     
I develop a dynamic framework that nests rational expectations (RE) and differences of opinion (DO) models to study how investors use prices to update their beliefs. I show that when investors condition on prices (RE), investor disagreement is related positively to return volatility and expected returns, but negatively to return autocorrelation. When investors do not use prices (DO), these relationships are reversed. I test these predictions on the cross-section of stocks using analyst forecast dispersion and volume as proxies for disagreement, and find that the evidence is consistent with investors using prices on average.

Keywords: rational expectations, difference of opinions, overlapping generations, disagreement

Working Paper Series