Unbiased Disagreement and the Efficient Market Hypothesis

Abstract

Can behavioral investors be neglected as long as they are rational on average? We show in this paper that there is an important impact of such investors on the behavior of financial markets, even though the pricing formulas are "on average" (over the states of the world) unchanged. In particular we obtain time varying, mean reverting and countercyclical (instead of constant in the standard model) market prices of risk, mean reverting and procyclical (instead of constant) risk free rates, decreasing (instead of flat) yield curves, possibly higher returns and higher risk premia in the long run (instead of a flat structure), more variance, time and state varying (instead of constant) risk sharing rules, as well as more important and procyclical trading volumes. These features seem consistent with the actual behavior of financial markets.

Keywords: Efficient Market Hypthesis, Disagreement, Irrational Investors, Noisy beliefs, Coutercyclical risk premia

JEL Classification: G12, G14, D84, E44