Sebastian Hillenbrand - Harvard Business School

"Heterogeneous Beliefs and Stock Market Fluctuations", with Odhrain McCarthy

Abstract

Stock prices aggregate the beliefs of different investors. Using this insight, we estimate the fraction of stock market investors holding survey beliefs. We find that 42% of investors hold beliefs matching those of equity analysts and 25% hold beliefs as observed in individual investor return surveys. Together with risk aversion proxies and rational cash flow forecasts constructed using machine learning techniques, survey beliefs explain 87% of stock market fluctuations. Because investors likely form their beliefs by extrapolating prices and cash flows, we find stock prices would fluctuate 50% less if all investors held rational beliefs. Allowing for investor heterogeneity and using a price driven price-to-earnings ratio reconciles prior studies.

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