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

See all articles by Jason C. Hsu

Jason C. Hsu

Rayliant Global Advisors; Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business

Bradford Cornell

California Institute of Technology

Date Written: July 21, 2014

Abstract

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

Hsu, Jason C. and Cornell, Bradford, The Self-fulfilling Prophecy of Popular Asset Pricing Models (July 21, 2014). Journal of Investment Management, vol. 14, no. 1, 2016. Available at SSRN: https://ssrn.com/abstract=2477069 or http://dx.doi.org/10.2139/ssrn.2477069

Jason C. Hsu (Contact Author)

Rayliant Global Advisors ( email )

Hong Kong

Research Affiliates, LLC ( email )

620 Newport Center Dr
Suite 900
Newport Beach, CA 92660
United States

HOME PAGE: http://www.jasonhsu.org

University of California, Los Angeles - Anderson School of Business

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Bradford Cornell

California Institute of Technology ( email )

Pasadena, CA 91125
United States
310-825-2922 (Phone)
310-206-5455 (Fax)

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