Learning from Prices and the Dispersion in Beliefs
48 Pages Posted: 15 Nov 2008 Last revised: 6 May 2010
Date Written: May 5, 2010
I develop a dynamic model that nests the rational expectations (RE) and differences of opinion (DO) approaches to study how investors use prices to update their valuations. I show that when investors condition on prices (RE), investor disagreement is related positively to expected returns, return volatility and market beta, 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 empirical evidence that is consistent with investors using prices on average.
Keywords: rational expectations, difference of opinions, overlapping generations, disagreement
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