Disagreement, portfolio optimization, and excess volatility

Ran Duchin*, Moshe Levy

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

11 Scopus citations

Abstract

Disagreement, a key factor inducing trading, has been receiving ever increasing attention in recent years. Most research has focused on disagreement about the expected returns. Several authors have shown that if the average belief coincides with the true expected return, in the portfolio context prices are unaffected by disagreement. In this paper we study the pricing effects of disagreement about return variances. We show that i) disagreement about variances has systematic and significant pricing effectsmore disagreement leads to higher prices, and ii) prices are very sensitive to the degree of disagreement: Even if the average belief about the variance is constant, tiny fluctuations in the disagreement about the variance lead to substantial price fluctuations. This second result may offer an explanation for the excess volatility puzzle: When small changes in the degree of disagreement occur, they induce relatively large price changes. Yet, the changes in disagreement may be hard to directly detect empirically, leading to apparent excess volatility.

Original languageAmerican English
Pages (from-to)623-640
Number of pages18
JournalJournal of Financial and Quantitative Analysis
Volume45
Issue number3
DOIs
StatePublished - Jun 2010

Bibliographical note

Funding Information:
∗Duchin, [email protected], University of Michigan at Ann Arbor, Ross School of Business, 701 Tappan St., Ann Arbor, MI 48109; Levy, [email protected], Jerusalem School of Business, Hebrew University, Jerusalem 91905, Israel. We are grateful to Stephen Brown (the editor) and Xavier Gabaix (the referee) for their helpful suggestions and insights. Financial support from the Zagagi Fund is gratefully acknowledged.

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