A Model of Equity Prices with Heterogeneous Beliefs

Abstract

This paper analyzes the effect of interaction among heterogeneous investors on equity prices. We classify investors into three groups according to their information sets and beliefs: informed investors, trend followers, and contrarians. Then, the equity price is derived through the market clearing condition. Our model explains many anomalous phenomena in the equity markets, including excess volatility, the momentum effect, and the mean-reverting effect. Further, the empirical analysis shows that the difference in returns behavior between small- and large-cap equities in the U.S. market can be explained by differences in the composition of investors.