Can Small Fluctuations in Investors’ Subjective Preferences Induce Large Volatility in Equity Prices?

Abstract

This paper focuses on the potential effects of small fluctuations in investors’ subjective preferences (specifically, their discount factors and attitudes towards risk) on the volatility of equity prices. We briefly summarize some of the arguments and evidence regarding the fluctuations in subjective preferences. Our analysis indicates that such fluctuations may have significant implications for understanding the volatility of the prices of financial assets.

We derive a closed-form expression for equilibrium equity prices, and use this expression to map the fluctuations in investors’ subjective preferences to the fluctuations in equity prices. Our analysis suggests that small fluctuations in the discount factor have potentially large effects on the latter. For example, if the standard deviation of the fluctuations in the discount factor is of the order of 1/10th of one percent, then this by itself can induce a 3 to 4 % standard deviation in the fluctuations in equity prices. The fluctuations in the attitude towards risk have a smaller, but nevertheless non-negligible effect. We present the intuition underlying our conclusions.