Volatility, Investor Uncertainty, and Dispersion
35 Pages Posted: 24 Dec 2011 Last revised: 3 Mar 2012
Date Written: December 23, 2011
This paper studies the aggregation of investor expectations of stock market return variation and its implications. We motivate theoretically that the market's expected return variance can be decomposed into the average of individuals' expected variance plus the dispersion in individuals' expected mean returns. The former can be seen as risk, while the latter is a measure of uncertainty. We illustrate this result empirically by setting up a unique survey measuring investors' expected returns and volatilities. Our finding is important to the issue of aggregating heterogeneous beliefs at the micro level in relation to pricing in financial markets. For instance, as a result it is almost per definition that individual investors are overconfident in the sense of overly narrow forecast bounds, due to neglecting individual differences of opinion about mean returns. We furthermore show that investors display a risk-return trade-off, whereas the market seems to price uncertainty.
Keywords: volatility, uncertainty, dispersion, survey data
JEL Classification: G11, D03
Suggested Citation: Suggested Citation