“Belief Dispersion in the Stock Market” by Suleyman Basak
London Business School
We develop a dynamic model of belief dispersion which simultaneously explains the empirical regularities in a stock price, its mean return, volatility, and trading volume. Our model with a continuum of (possibly Bayesian) investors differing in beliefs is tractable and delivers exact closed form solutions. Our model has the following implications. We find that the stock price is convex in cash-ow news, and it increases in belief dispersion while its mean return decreases when the view on the stock is optimistic, and vice versa when pessimistic. We also show that the presence of belief dispersion leads to a higher stock volatility, trading volume, and a positive relation between these two quantities. Furthermore, we demonstrate that the more familiar, otherwise identical, two-investor economies with heterogeneous beliefs do not necessarily generate our main results. Our quantitative analysis reveals that the effects of belief dispersion are economically significant and support the empirical evidence.