Diverse Risk Preferences and Heterogeneous Expectations in an Asset Pricing Model

76 Pages Posted: 12 Jan 2020

See all articles by Thomas Gomez

Thomas Gomez

Utrecht University

Giulia Piccillo

Maastricht University; Liverpool University; Utrecht University - School of Economics

Date Written: 2019

Abstract

We propose a heuristic switching model of an asset market where the agents' choice of heuristic is consistent with their individual risk aversion. They choose between a fundamentalist and a trend-following rule to form expectations about the price of a risky asset. Given their risk aversion, agents make a deterministic trade-off between mean and variance both in choosing a forecasting heuristic and determining the number of risky assets to buy. Heterogeneous risk preferences can lead to diverse choices of heuristic. Using empirical estimates for the distribution of risk aversion, simulations show that the resulting time-varying heterogeneity of expectations can give rise to chaotic dynamics: irregular booms and busts in the asset price without exogenous shocks. Small, stochastic price shocks lead to larger asset price bubbles, and can make stable solutions explosive. We prove that a representative agent cannot capture our model.

Keywords: heterogeneous risk aversion, bounded rationality, heterogeneous expectations, heuristic switching, asset pricing

JEL Classification: D810, D840, G110, G120, G410

Suggested Citation

Gomez, Thomas and Piccillo, Giulia, Diverse Risk Preferences and Heterogeneous Expectations in an Asset Pricing Model (2019). CESifo Working Paper No. 8003, Available at SSRN: https://ssrn.com/abstract=3517050

Thomas Gomez (Contact Author)

Utrecht University ( email )

Vredenburg 138
Utrecht, 3511 BG
Netherlands

Giulia Piccillo

Maastricht University ( email )

P.O. Box 616
Maastricht, 6200 MD
Netherlands

Liverpool University ( email )

Eleanor Rathbone Building
Bedford Street North
Liverpool L69 7ZA
United Kingdom

Utrecht University - School of Economics ( email )

Kriekenpitplein 21-22
Adam Smith Building
Utrecht, +31 30 253 7373 3584 EC
Netherlands

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