Heterogeneity, Selection, and Wealth Dynamics (original) (raw)

If You're so Smart, why Aren't You Rich? Belief Selection in Complete and Incomplete Markets

Econometrica, 2006

This paper provides an analysis of the asymptotic properties of Pareto optimal consumption allocations in a stochastic general equilibrium model with heterogeneous consumers. In particular we investigate the market selection hypothesis, that markets favor traders with more accurate beliefs. We show that in any Pareto optimal allocation whether each consumer vanishes or survives is determined entirely by discount factors and beliefs. Since equilibrium allocations in economies with complete markets are Pareto optimal, our results characterize the limit behavior of these economies. We show that, all else equal, the market selects for consumers who use Bayesian learning with the truth in the support of their prior and selects among Bayesians according to the size of their parameter space. Finally, we show that in economies with incomplete markets these conclusions may not hold. With incomplete markets payoff functions can matter for long run survival, and the market selection hypothesis fails.

Selection in asset markets: the good, the bad, and the unknown

Journal of Evolutionary Economics, 2013

In this paper, we use a series of simple examples to illustrate how wealthdriven selection works in a market for Arrow securities. Our analysis delivers both a good and a bad message. The good message is that, when traders invest constant fractions of their wealth in each asset and have equal consumption rates, markets are informationally efficient: the best informed agent is rewarded and asset prices eventually reflect this information. However, and this is the bad message, when asset demands are not constant fractions of wealth but dependent upon prices, markets might behave sub-optimally. In this case, asymptotic prices depend on preferences and beliefs of the whole ecology of traders and do not, in general, reflect the best available information. We show that the key difference between the two cases lies in the local, i.e. price dependent, versus global nature of wealth-driven selection.

Market Selection and Asset Pricing for the Handbook of Financial Markets : Dynamics and Evolution

2008

In this chapter we survey asset pricing in dynamic economies with heterogeneous, rational traders. By ‘rational’ we mean traders whose decisions can be described by preference maximization, where preferences are restricted to those which have an subjective expected utility (SEU) representation. By ’heterogeneous” we mean SEU traders with different and distinct payoff functions, discount factors and beliefs about future prices which are not necessarily correct. We examine whether the market favors traders with particular characteristics through the redistribution of wealth, and the implications of wealth redistribution for asset pricing. The arguments we discuss on the issues of market selection and asset pricing in this somewhat limited domain have a broader applicability. We discuss selection dynamics on Gilboa-Schmeidler preferences and on arbitrarily specified investment and savings rules to see what discipline, if any, the market wealth-redistribution dynamic brings to this envi...

Wealth Selection in a Financial Market with Heterogeneous Agents

2007

We study the co-evolution of asset prices and agents' wealth in a financial market populated by an arbitrary number of heterogeneous, boundedly rational, investors. We model assets' demand to be proportional to agents' wealth, so that wealth dynamics can be used as a selection device. For a general class of investment behaviors, we are able to characterize the long run market outcome, i.e. the steady-state equilibrium values of asset return, and agents' survival. Our investigation illustrates that market forces pose certain limits on the outcome of agents' interactions even within the "wilderness of bounded rationality". As an application we show that our analysis provides a rigorous explanation for the results of the simulation model introduced in Levy, Levy, and Solomon (1994).

Wealth-driven Selection in a Financial Market with Heterogeneous Agents

2009

We study the co-evolution of asset prices and individual wealth in a financial market populated by an arbitrary number of heterogeneous, boundedly rational agents. Using wealth dynamics as a selection device we are able to characterize the long run market outcomes, i.e. asset returns and wealth distributions, for a general class of investment behaviors. Our investigation illustrates that market interaction and wealth dynamics pose certain limits on the outcome of agents' interactions even within the "wilderness of bounded rationality". As an application we consider the case of heterogeneous meanvariance optimizers and provide insights into the results of the simulation model introduced by Levy, Levy and Solomon (1994).

If You\u27re So Smart, Why Aren\u27t You Rich?Belief Selection in Complete and Incomplete Markets

2001

This paper provides an analysis of the asymptotic properties of consumption allocations in a stochastic general equilibrium model with heterogeneous consumers. In particular we investigate the market selection hypothesis, that markets favor traders with more accurate beliefs. We show that in any Pareto optimal allocation whether each consumer vanishes or survives is determined entirely by discount factors and beliefs. Since equilibrium allocations in economies with complete markets are Pareto optimal, our results characterize the limit behavior of these economies. We show that, all else equal, the market selects for consumers who use Bayesian learning with the truth in the support of their prior and selects among Bayesians according to the size of the their parameter space. Finally, we show that in economies with incomplete markets these conclusions may not hold. Payoff functions can matter for long run survival, and the market selection hypothesis fails

Heterogeneous beliefs, wealth accumulation, and asset price dynamics

Journal of Economic Dynamics and Control, 1996

seminar audience at UCSD for their helpful comments. Abstract A model of asset markets with two types of investors is developed and its dynamic properties are analyzed. "Optimists" expect on average higher returns on the risky assets than "pesaimists" do. The stochastic procesa íor equilibrium asset return changes over time as the distribution oí wealth between the two types oí investors changes. In the long run, the share oí wealth held by one type oí investor may become negligible, but it is a180 poesible íor both types to co-exist, depending on the parameter values of the model. Relations between this model and sorne econometric models with time varying parameters, such as the ARCH (Autoregresaive Conditional Heteroskedasticity) model and the STAR (Smooth Transition Autoregresaive) model, are examined. The dynamic properties oí another model, regarding investors who use strategies that are a bit more complex, are al80 analyzed. "Fundamentalists" believe that the asset returns íollow a procesa that is solely determined by íundamentals and "contrarians" assume the market is wrong and choose a portfolio that is exactly opposite of the market portíolio. Again, depending on parameters, both types can co-exist even in the long runo 2

Asset Prices with Heterogeneity in Preferences and Beliefs

Review of Financial Studies, 2014

In this paper, we study asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have power utility and differ with respect to both beliefs and their preference parameters for time discount and risk aversion. We solve in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. Our solution allows us to identify the strengths and limitations of the model with heterogeneity in both preferences and beliefs. We find that beliefs about the mean growth rate of the aggregate endowment that are pessimistic on average (across investors) lead to a significant increase in the market price of risk, while heterogeneity in risk aversion increases stock-return volatility. Consequently, the equity risk premium, which is the product of the market price of risk and stock return volatility, is considerably higher in the model where average beliefs are pessimistic and risk aversions are heterogeneous, and this is not accompanied by an increase in either the level or the volatility of the short-term riskless rate. The main limitation of the model is that it is stationary only for a restricted set of parameter values, and for these parameter values one can get a high market price of risk and equity risk premium but not excess stock return volatility.

Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices

Journal of Political Economy, 2002

We examine how cross-sectional heterogeneity in preferences affects equilibrium behavior of asset prices. We obtain explicit characterization of the competitive equilibrium in an exchange economy in which individual agents have catching up with the Joneses preferences and differ only with respect to the curvature of their utility functions. We show that heterogeneity can have a drastic effect on the behavior of asset prices, in particular, on their conditional moments. Dynamic redistribution of wealth among the agents in heterogeneous economies leads to time-variation in aggregate risk aversion and market price of risk, generating empirically observed negative relation between conditional return volatility and expected returns on one hand and the level of stock prices on the other hand. This stands in contrast with the behavior of homogeneous economies with the same preferences, in which such relation is positive. Quantitatively, the heterogeneous model is capable of replicating various empirical properties of asset prices.