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Disagreement, Portfolio Optimization, and Excess Volatility

  • Duchin, Ran
  • Levy, Moshe

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 effects—more 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.”

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 45 (2010)
Issue (Month): 03 (June)
Pages: 623-640

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Handle: RePEc:cup:jfinqa:v:45:y:2010:i:03:p:623-640_00
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