Posted: 19 Mar 2005
Date Written: February 25, 2005
This paper analyzes the effects of buy and hold investors on security price dynamics in a pure-exchange, continuous-time model. Empirical studies suggest that many defined contribution plan participants follow buy and hold strategies by rarely changing asset and flow allocations due to information costs or other frictions. Similar strategies are documented for institutional investors. A buy and hold investor effectively faces an incomplete market and differs in her pricing of risk from a dynamic asset allocator. Construction of an equilibrium is achieved through a representative agent with state-dependent utility. The fraction of the stock held by the buy and hold investor emerges as an additional state variable. Characterizations of equilibrium quantities are given analytically as functions of the state variables. A simple calibration of our model shows that the economy with buy and hold investors can simultaneously produce a low interest rate and a high Sharpe ratio. Moreover, the model can deliver a stock return volatility more than twice that in the limited participation model. Intuition for these results is also provided.
Keywords: equilibrium asset pricing, incomplete market, equity premium puzzle, buy and hold investor
JEL Classification: G12
Suggested Citation: Suggested Citation
Wu, Tao L., An Equilibrium Model with Buy and Hold Investors (February 25, 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=686409