The Self-fulfilling Prophecy of Popular Asset Pricing Models
Journal of Investment Management, vol. 14, no. 1, 2016
Posted: 8 Aug 2014 Last revised: 28 Dec 2016
Date Written: July 21, 2014
The assumption that asset prices are determined by the efforts of end investors to maximize inter-temporal utility supports a pricing theory that is both elegant and intuitive. Unfortunately, the assumption is counterfactual. End investors, with few exceptions, lack the capacity to behave in a fashion consistent with the theory. More to the point, they don’t try. Instead, they delegate investment decision-making. Thus, it is important to understand the investment management ecosystem. Is it a simple pass-through mechanism? We do not believe so and argue, instead, that the lack of alignment implies the cross-section of asset returns is significantly influenced by active money managers and deviates from the predictions of the consumption-based model. Using a simple thought experiment, we demonstrate that the widely adopted discounted cash flow model is likely both to drive prices and to determine the cross-section of average returns. This leads to a self-fulfilling feedback loop in which once an asset pricing model is adopted by active managers as a means of estimating the discount rate, it becomes a determinant of expected returns.
Keywords: asset pricing, expected returns, behavioral finance, discounted cash flows, utility functions
JEL Classification: G12, G20
Suggested Citation: Suggested Citation