Hostname: page-component-7479d7b7d-k7p5g Total loading time: 0 Render date: 2024-07-13T13:32:58.625Z Has data issue: false hasContentIssue false
  • English
  • Français

Disagreement, Portfolio Optimization, and Excess Volatility

Published online by Cambridge University Press:  31 March 2010

Ran Duchin  and
Moshe Levy
Ran Duchin
Affiliation:
University of Michigan at Ann Arbor, Ross School of Business, 701 Tappan St., Ann Arbor, MI 48109. duchin@umich.edu
Moshe Levy
Affiliation:
Jerusalem School of Business, Hebrew University, Jerusalem 91905, Israel. mslm@huji.ac.il
Get access Rights & Permissions [Opens in a new window]

Abstract

Disagreement, a key factor inducing trading, has been receiving ever increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return, in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement about return variances. We show that i) disagreement about variances has systematic and significant pricing effects—more disagreement leads to higher prices, and ii) prices are very sensitive to the degree of disagreement: Even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: When small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent “excess volatility.”

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 3 , June 2010 , pp. 623 - 640
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Admati, A. “A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets.” Econometrica, 53 (1985), 629–657.Google Scholar
Aumann, R. J. “Agreeing to Disagree.” Annals of Statistics, 4 (1976), 1236–1239.CrossRefGoogle Scholar
Barry, C. B., and Brown, S. J.. “Differential Information and the Small Firm Effect.” Journal of Financial Economics, 13 (1984), 283–294.CrossRefGoogle Scholar
Barry, C. B., and Brown, S. J.. “Differential Information and Security Market Equilibrium.” Journal of Financial and Quantitative Analysis, 20 (1985), 407–422.CrossRefGoogle Scholar
Biais, B.; Bossaerts, P.; and Spatt, C.. “Equilibrium Asset Pricing and Portfolio Choice under Asymmetric Information.” Review of Financial Studies, 23 (2010), 1503–1543.Google Scholar
Cochrane, J. H. Asset Pricing. Princeton, NJ: Princeton University Press (2001).Google Scholar
David, A. “Heterogeneous Beliefs, Speculation, and the Equity Premium.” Journal of Finance, 63 (2008), 41–83.Google Scholar
DeMarzo, P., and Skiadas, C.. “Aggregation, Determinacy, and Informational Efficiency for a Class of Economies with Asymmetric Information.” Journal of Economic Theory, 80 (1998), 123–152.CrossRefGoogle Scholar
Dumas, B.; Kurshev, A.; and Uppal, R.. “Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility.” Journal of Finance, 64 (2009), 579–629.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Disagreement, Tastes, and Asset Prices.” Journal of Financial Economics, 83 (2007), 667–689.Google Scholar
Gollier, C. “Whom Should We Believe? Aggregation and Heterogeneous Beliefs.” Journal of Risk and Uncertainty, 35 (2007), 107–127.CrossRefGoogle Scholar
Harris, M., and Raviv, A.. “Differences of Opinion Make a Horse Race.” Review of Financial Studies, 6 (1993), 473–506.CrossRefGoogle Scholar
Jorion, P. “International Portfolio Diversification with Estimation Risk.” Journal of Business, 58 (1985), 259–278.Google Scholar
Kandel, E., and Pearson, N.. “Differential Interpretation of Public Signals and Trade in Speculative Markets.” Journal of Political Economy, 103 (1995), 831–872.CrossRefGoogle Scholar
LeRoy, S. “Efficient Capital Markets and Martingales.” Journal of Economic Literature, 27 (1989), 1583–1622.Google Scholar
LeRoy, S., and Porter, R.. “The Present-Value Relation: Tests Based on Implied Variance Bounds.” Econometrica, 44 (1981), 555–574.CrossRefGoogle Scholar
Levy, H. “The Demand for Assets Under Conditions of Risk.” Journal of Finance, 28 (1973), 79–96.CrossRefGoogle Scholar
Levy, H.; Levy, M.; and Benita, G.. “Capital Asset Prices with Heterogeneous Beliefs.” Journal of Business, 79 (2006), 1317–1354.Google Scholar
Levy, H., and Markowitz, H.. “Approximating Expected Utility by a Function of Mean and Variance.” American Economic Review, 69 (1979), 308–317.Google Scholar
Levy, M. “Conditions for a CAPM Equilibrium with Positive Prices.” Journal of Economic Theory, 137 (2007), 404–415.Google Scholar
Levy, M., and Roll, R.. “The Market Portfolio May be Mean/Variance Efficient After All.” Review of Financial Studies, 23 (2010), 2464–2491.Google Scholar
Lintner, J. “The Aggregation of Investor’s Diverse Judgments and Preferences in Purely Competitive Security Markets.” Journal of Financial and Quantitative Analysis, 4 (1969), 347–400.Google Scholar
Merton, R. C. “An Analytic Derivation of the Efficient Portfolio Frontier.” Journal of Financial and Quantitative Analysis, 7 (1972), 1851–1872.Google Scholar
Merton, R. C. “On Estimating the Expected Return on the Market.” Journal of Financial Economics, 8 (1980), 323–361.Google Scholar
Nielsen, L. T. “Uniqueness of Equilibrium in the Classical CAPM.” Journal of Financial and Quantitative Analysis, 23 (1988), 329–336.CrossRefGoogle Scholar
Nielsen, L. T. “Positive Prices in CAPM.” Journal of Finance, 47 (1992), 791–808.CrossRefGoogle Scholar
Shiller, R. J. “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends? ” American Economic Review, 76 (1981), 421–435.Google Scholar
Shiller, R. J. “From Efficient Markets Theory to Behavioral Finance.” Journal of Economic Perspectives, 17 (2003), 83–104.Google Scholar
Welch, I. “Views of Financial Economists on the Equity Premium and on Professional Controversies.” Journal of Business, 73 (2000), 501–537.CrossRefGoogle Scholar
West, K. “Bubbles, Fads, and Stock Price Volatility Tests: A Partial Evaluation.” Journal of Finance, 48 (1988), 639–656.Google Scholar
Yan, H. “Is Noise Trading Canceled Out by Aggregation?” Management Science, forthcoming (2010).CrossRefGoogle Scholar