Behavioral Heterogeneity in Stock Prices

Abstract

We estimate a behavioral asset pricing model characterized by heterogeneous boundedly rational agents. The fundamental value of the risky asset is publicly available to all agents, but they have different beliefs about the persistence of deviations of stock prices from the fundamental benchmark. An evolutionary selection mechanism based on past profits determines the dynamics of the fractions and switching of agents between different forecasting strategies. A strategy attracts more agents if it performed relatively well in the recent past compared to other strategies. We estimate the model to annual US stock price data from 1871 until 2003. The estimation results support the existence of two expectation regimes. One regime can be characterized as a bubble regime because agents expect the deviations from the fundamental to trend; the second regime is characterized by beliefs of mean reversion toward the benchmark value. The fraction of agents using the predictors shows substantial time variation and switching between predictors. The model offers an explanation for the recent stock prices run-up. Before the 90s, the bubble regime was active only occasionally. However, in the late 90s, the bubble regime persisted and created an extraordinary deviation of stock prices from the fundamentals. Recently, the activation of the mean reverting regime has contributed to drive the price back toward the fundamental valuation.

Keywords: Asset pricing, behavioral finance, bounded rationality

JEL Classification: G12, G14