Investor Beliefs and Trading Frictions

Abstract

I develop a theoretical framework to identify investors' subjective beliefs consistent with survey expectations and asset prices in markets with trading frictions. I introduce a metric to quantify the deviation of these beliefs from Rational Expectations (RE), interpretable as a bound on the difference between the maximum Sharpe Ratios under investors' beliefs and RE. Empirically, I show that a significant share of the deviation from RE, assessed assuming frictionless markets, can be attributed to small trading costs. This deviation and the impact of trading costs differ across investor characteristics, with sophisticated investors' expectations more closely aligning with asset prices.

Keywords: Subjective Beliefs, Rational Expectations, Survey Expectations, Market Frictions

JEL Classification: G10, G40