No Short in Sight

Abstract

In our economy with short-sales constraints and learning from experience, constrained investors become nonparticipants and have reduced attention to the stock market. Fluctuations in the market view are elevated, learning is slower in the aggregate, the market price of risk and the real short rate of interest are more volatile than in an unconstrained economy. Exuberance-driven investors enter the stock market with high leverage in times of low market price of risk and exit in disappointment. If nonparticipants never reenter, the market price of risk can be higher, implying a large wedge between average returns for participants and nonparticipants.

Keywords: Short-Sales Constraint, Learning from Experience, Reduced Attention to Signal, Endogenous Non-participation

JEL Classification: E2, G10, G11, G12