The authors, well known for their three-factor model of asset prices, offer a
simple framework for studying how disagreement in the payoffs of assets and a
taste for assets as consumption goods can impact security prices. Their approach
relies on a market-equilibrium argument that indicates that both conditions have
an impact on price, although the size of that impact is not certain.
Two unrealistic assumptions underlie standard asset-pricing models. The first assumption
is that investors are in complete agreement regarding the probability distributions of
future asset payoffs. The second assumption is that investment assets are not used for
personal consumption and are selected solely based on their anticipated payoffs. The
authors develop a simple framework for assessing how, if both assumptions are dropped,
asset prices are affected.
The well-known capital asset pricing model (CAPM), introduced by Sharpe in 1964, and its
subsequent iterations (the most notable of which is Merton’s intertemporal CAPM,
the ICAPM) are problematic, in that they fail to explain average stock returns, being
challenged primarily by the inability to capture the impacts of the value premium and
momentum on price. The literature does address the weaknesses of the standard model in
terms of payoff disagreement—beginning as far back as 40 years ago with Lintner
(
terms of asset consumption. The “disagreement” literature tends to be
largely mathematical in nature, which the authors seek to overcome by their focus on a
simple approach. And the “tastes” literature cites reasons for holding
assets other than a pure play on their anticipated payoffs, including holding an
employer’s stock, socially responsible investing, and home bias.
The authors’ discussion of how disagreement affects price stands on a
market-equilibrium platform. In a state of equilibrium, price operates to induce
informed investors in aggregate to overweight (relative to the market) assets that are
underweighted (relative to the market) by poorly informed investors. When investors are
risk averse, however, equilibrium is only partial and prices retain vestiges of
misinformation. Regardless of the persistent actions of informed investors, equilibrium
cannot be achieved until misinformed investors become informed. In other words, informed
investors have no incentive to bring prices back into equilibrium. The authors
characterize their argument as a market-equilibrium version of the “limits of
arbitrage” argument of Shleifer and Vishny (
1997).
Market equilibrium also regulates price in the realm of investor preferences, or tastes,
for assets viewed as consumption goods. As in the case of misinformed investors, asset
prices must induce overweighting by investors who do not attribute utility to assets for
consumption purposes, offsetting the underweighting by those who do. Equilibrium is only
partial (i.e., prices do not conform to the CAPM) when the amount of specific assets
held by the two groups is not perfectly offsetting. In an intertemporal setting,
equilibrium pricing does exist when investor decision making is driven by the
covariances of asset returns with common return factors or state variables.
The authors undertake a series of calibrations of their model as they seek to determine
to what degree expected returns and misinformed beliefs impact pricing. The calibrations
show that distortions in expected returns can be large when misinformed investors or
investors who value assets as consumption goods account for substantial invested wealth,
invest in a wide range of assets, take positions far different from the market
portfolio, or underweight assets with returns not highly correlated with the returns on
the assets they overweight. Although the impact on expected returns can be large, the
impact on price was not determinable.
Useful insights gained by the authors through their calibration studies include the
following observations. Informed investors earn positive alphas whereas uninformed
investors earn negative alphas. And although the price impact of decisions made by
investors who have a taste for assets as consumption goods is similar to the price
impact of decisions made by misinformed investors, the price effects induced by
misinformed investors are temporary whereas those arising from investors with differing
tastes are not. Additionally, the authors conclude that because costs are
equal-opportunity distortions (i.e., they equally hinder both misinformed and informed
investors), the net effect of costs on market efficiency is unclear.