Divergent Expectations: When Investors Agree to Disagree

Abstract

Investors who possess the same information and interpret it differently are said to have divergent (as distinct from) homogeneous expectations. Financial economists have widely frowned on the divergent expectations assumption. Nevertheless, this assumption describes reality and is critically important. It paves the way to understanding price and quantity discovery as major functions of a marketplace, and it goes to the heart of an important question - what drives trading and why does market structure matter? Many issues concerning market structure and market structure regulation should be analyzed in a divergent expectations context. This paper considers what is involved in terms of market participants and public policy.

Keywords: market microstructure, asset valuation, heterogeneous expectations, theory

JEL Classification: G14, G12, D82, D83, D84