Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth?

Abstract

Abandoning the representative agent framework to introduce heterogeneity of beliefs across different agents allows us to build a link between wealth distribution and the equity premium. We demonstrate that an economy populated only by risk neutral agents may nonetheless display a strictly positive equity premium. Moreover, belief heterogeneity provides a possible explanation of the temporal evolution of the premium.

We then place our notion of beliefs heterogeneity within the popular representative agent construct and argue that, given any level of belief heterogeneity, equilibrium prices in a multi agent economy can be replicated in a representative agent economy assuming a particular degree of risk aversion. A fully dynamic model of consumption based asset pricing with belief heterogeneity follows.

Finally, we suggest an explanation for the market behavior of the equity premium in the last decade: a story of heterogeneous optimism versus homogeneous pessimism is presented.

Keywords: Belief heterogeneity, equity premium puzzle, representative agent, risk aversion, wealth distribution

JEL Classification: D31, D84, G12