Heterogeneous Beliefs and Stock Market Fluctuations

Abstract

This paper examines the role of heterogeneous investor beliefs in explaining stock market puzzles. Using survey data, we show that individual investors and investment professionals, such as equity analysts and strategists, form distinct beliefs. These investor groups rely on different information sources when forming expectations and frequently hold opposing views, with a−47% correlation in return expectations. This belief heterogeneity proves important for understanding stock market puzzles: jointly, investors’ beliefs account for 74% of stock price variation and 34% of 3-year future return variation, with the beliefs of each investor group having large independent explanatory power. We show that a model incorporating both cash flow- and price-extrapolating investors can account for three key features of financial markets: (i) the belief dynamics and heterogeneity observed in survey data, (ii) excess stock price volatility, and (iii) return predictability.

Keywords: Heterogeneous beliefs, extrapolative expectations, stock market valuation, asset pricing, survey expectations, price decomposition

JEL Classification: G11, G12, G4