Heterogeneity, Bounded Rationality and Market Dysfunctionality

Xuezhong (Tony) He () and Lei Shi ()

No 233, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: As the main building blocks of the modern finance theory, homogeneity and rational expectation have faced difficulty in explaining many market anomalies, stylized factors, and market inefficiency in empirical studies. As a result, heterogeneity and bounded rationality have been used as an alterative paradigm of asset price dynamics and this paradigm has been widely recognized recently in both academic and financial market practitioners. Within the framework of Chiarella, Dieci and He (2006a, 2006b) on mean-variance analysis under heterogeneous beliefs in terms of either the payoffs or returns of the risky assets, this paper examines the effect of the heterogeneity. We first demonstrate that, in market equilibrium, the standard one fund theorem under homogeneous belief does not held under heterogeneous belief in general, however, the optimal portfolios of investors are very close to the market efficient frontier. By imposing certain distribution assumption on the heterogeneous beliefs, we then use Monte Carlo simulations to show that certain heterogeneity among investors can improve the Sharpe and Treynor ratios of the portfolios and investors can benefit from the diversity in investors’ beliefs. We also show that non-normality of market equilibrium return distributions is an outcome of the market aggregation of individual investors who make rational decisions based on their beliefs. Our results explain the empirical funding that that managed funds under-perform the market index on average and show that heterogeneity can improve the market efficiency.

Keywords: heterogeneity; bounded rationality; heterogeneous CAPM; mean-variance efficiency; Sharpe and Treynor ratios (search for similar items in EconPapers)
JEL-codes: D84 G12 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2008-10-01
New Economics Papers: this item is included in nep-cbe
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