Beliefs Aggregation and Return Predictability

Abstract

We study return predictability using a model of speculative trading among relatively overconfident competitive traders who agree to disagree about the precision of their private information. Although traders apply Bayes Law consistently, returns are predictable. In addition to trading on long-term fundamental value, traders also trade on perceived short-term opportunities arising from foreseen future disagreement, as in a Keynesian beauty contest. Contradicting conventional wisdom, this short-term speculation dampens rather than magnifies price fluctuations relative to fundamentals, generating time-series momentum. Consistent with model predictions, we find empirically more pronounced momentum for stocks with higher trading volume.

Keywords: asset pricing, predictability, market microstructure, market efficiency, momentum, mean-reversion, anomalies, agreement to disagree

JEL Classification: B41, D8, G02, G12, G14