Heterogeneous Investors and Stock Market Fluctuations

By: Odhrain McCarthy and Sebastian Hillenbrand

Format:Print
| Language:English
| Pages:63

Abstract

We introduce a heterogeneous agent model which features extrapolative beliefs and time-varying risk aversion. The model leads to an empirical framework which we estimate with stock prices, survey data and risk aversion measures. We find that extrapolative beliefs and risk aversion are important drivers of stock prices together explaining 86% of movements in the S&P500 index: extrapolative cash flow expectations explain 34%, extrapolative return expectations explain 23% and time-variation in risk aversion explains 29%. We also find that stock prices would vary by roughly 70% less if all investors were to hold rational beliefs. Our work highlights that investor heterogeneity and the use of survey data to measure their beliefs are key to understanding asset prices.