Belief Heterogeneity and Risk Amplification

Abstract

Do heterogeneous beliefs amplify systemic shocks? I set out a tractable model that incorporates heterogeneous beliefs and assesses their interaction with endogenous risk. Incomplete information often leads investors to form heterogeneous beliefs when they optimize their portfolios; optimists consider their expected productivity growth to be higher than pessimists. My results suggest that, when optimists are associated with the more productive part of the economy, belief heterogeneity increases asset prices, investment and leverage, reducing the expected duration of upcoming recessions substantially. However, it exacerbates risk amplification, significantly more than what standard models predict, contributing to a deeper understanding of what drives excess volatility.