Heterogeneous Beliefs as a Source of Momentum and Reversal

Summary

This paper develops a theoretical account of stock-price predictability based on investors holding different beliefs. In a finite-time model, some investors receive noisy information about an asset’s fundamental value, while investors also disagree about stochastic supply. Some underestimate the accuracy of the signal. Their response dampens its initial effect on price, which can produce momentum as the market’s reaction unfolds; over the longer run, price moves back toward fundamental value, producing reversal.

The model’s extension to multiple assets predicts co-movement and lead-lag relationships alongside cross-sectional momentum and reversal. The paper offers a mechanism for these patterns within a bounded-rationality model, rather than empirical evidence that they occur or can be traded profitably. Its implications rest on the model’s assumptions about information, signal accuracy, supply beliefs, and price adjustment. The provided description gives no calibration, data tests, or practical trading rules with which to assess the predictions empirically.

Key ideas

• Investors differ in their beliefs about stochastic supply and the accuracy of noisy signals.
• Underestimating signal accuracy can dampen the signal’s initial price impact.
• The model links the delayed price response to momentum and longer-run adjustment to reversal.
• In a multi-asset setting, the model predicts co-movement and lead-lag effects.
• These patterns are theoretical predictions, not empirical evidence of profitable strategies.

Tags

# Heterogeneous Beliefs Model of Stock Market Predictability


# Heterogeneous Beliefs Model of Stock Market Predictability









This paper proposes a theory of stock market predictability patterns based on a model of heterogeneous beliefs. In a discrete finite time framework, some agents receive news about an asset's fundamental value through a noisy signal. The investors are heterogeneous in that they have different beliefs about the stochastic supply. A momentum in the stock price arises from those agents who incorrectly underestimate the signal accuracy, dampening the initial price impact of the signal. A reversal in price occurs because the price reverts to the fundamental value in the long run. An extension of the model to multiple assets case predicts co-movement and lead-lag effect, in addition to cross-sectional momentum and reversal. The heterogeneous beliefs of investors about news demonstrate how the main predictability anomalies arise endogenously in a model of bounded rationality.

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