Disagreement, Portfolio Optimization, and Excess Volatility

28 Pages Posted: 16 Jun 2008 Last revised: 27 Oct 2009

See all articles by Ran Duchin

Ran Duchin

University of Washington - Michael G. Foster School of Business

Moshe Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Date Written: June 1, 2008

Abstract

Disagreement is a key factor inducing trading, which has been receiving ever-increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement regarding return variances. We show that 1) disagreement about variances has systematic and significant pricing effects, and 2) prices are very sensitive to the degree of disagreement: even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: when small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent "excess volatility".

Keywords: heterogeneous beliefs, portfolio optimization, excess volatility

JEL Classification: G11, G12, G18

Suggested Citation

Duchin, Ran and Levy, Moshe, Disagreement, Portfolio Optimization, and Excess Volatility (June 1, 2008). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming. Available at SSRN: https://ssrn.com/abstract=1146202

Ran Duchin (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

Moshe Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

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