Heterogeneous Beliefs Model of Stock Market Predictability

TL;DR

This paper introduces a model where heterogeneous investor beliefs about news and supply cause predictable stock market patterns like momentum and reversals, explaining anomalies endogenously within bounded rationality.

Contribution

It develops a novel heterogeneous beliefs model that explains stock market predictability patterns and anomalies through investor belief differences and noisy signals.

Findings

Price momentum arises from underestimating signal accuracy.

Prices revert to fundamentals in the long run.

Model predicts co-movement and lead-lag effects across assets.

Abstract

This paper proposes a theory of stock market predictability patterns based on a model of heterogeneous beliefs. In a discrete finite time framework, some agents receive news about an asset's fundamental value through a noisy signal. The investors are heterogeneous in that they have different beliefs about the stochastic supply. A momentum in the stock price arises from those agents who incorrectly underestimate the signal accuracy, dampening the initial price impact of the signal. A reversal in price occurs because the price reverts to the fundamental value in the long run. An extension of the model to multiple assets case predicts co-movement and lead-lag effect, in addition to cross-sectional momentum and reversal. The heterogeneous beliefs of investors about news demonstrate how the main predictability anomalies arise endogenously in a model of bounded rationality.