Recovering Heterogeneous Beliefs and Preferences from Asset Prices

Abstract

We propose a novel information-theoretic approach to separately identify the risk preferences and beliefs of different types of financial market investors. Investors who allocate most of their wealth in large market capitalization stocks are risk averse and believe that the aggregate stock market return is strongly countercyclical. In contrast, investors in small-growth stocks are substantially less risk averse and believe in procyclical expected stock market returns. Our findings can reconcile the procyclical expected market returns found in investor survey data with the countercyclical expected returns implied by rational expectations models.