Recovering Heterogeneous Beliefs and Preferences from Asset Prices

Abstract

We propose a novel information-theoretic approach to identify the risk preferences and beliefs of different investor types. Investors who optimally allocate most of their wealth to large market capitalization stocks are risk averse and believe that the stock market return, and its Sharpe ratio, are countercyclical. Investors in value stocks have similar risk preferences and beliefs. In contrast, investors in momentum and small-growth stocks have procyclical beliefs. Momentum (small-growth) investors are more (less) risk-averse than the large-cap investor. Our findings can reconcile the procyclical expected market returns in survey data with the countercyclical expected returns implied by rational expectations models.

Keywords: asset pricing, beliefs, preferences, heterogeneity, business cycle, rational expectations, behavioral finance, smoothed empirical likelihood

JEL Classification: C51, E3, E70, G12, G14, G40