Abstract: We use the long-term Capital Market Assumptions of major asset managers and institutional investor consultants from 1987 to 2022 to provide three stylized facts about their subjective risk and return expectations on 19 asset classes. First, there is a strong and positive subjective risk-return tradeoff, with most of the variability in subjective expected returns due to variability in subjective risk premia compensation for market beta) as opposed to subjective alphas. Second, belief variation and the positive risk-return tradeoff are both stronger across asset classes than across institutions. And third, the subjective expected returns of these institutions predict subsequent realized returns across asset classes and over time. Taken together, our findings imply that models with subjective beliefs should reflect a risk-return tradeoff. Additionally, accounting for this subjective risk-return tradeoff when modeling multiple asset classes is even more important than incorporating average belief distortions or belief heterogeneity in our setting.
Luis Filipe Goncalves-Pinto, University of New South Wales
Herve Roche, University of Chile
Juan Sotes-Paladino, Universidad de los Andes
Abstract: Against a prediction of standard models, an exacerbation of investor sentiment is often associated with lower stock return volatility in the data. We propose a model that can replicate this empirical pattern by interacting retail investor optimism with institutional benchmarking concerns. Both optimism and benchmarking separately increase the demand for a stock and decrease its risk premium. In contrast, their joint effect on return volatility is more ambiguous, as the transmission of fundamental news to prices combines benchmarking and relative-wealth channels. The latter channel, in particular, can induce a negative and asymmetric relation between investor sentiment and the stock return's excess volatility. It also explains how a greater institutionalization of financial markets can reduce excess volatility and mispricing in the presence of high sentiment.
We show that these patterns are consistent with the data.
Discussant: Goutham Gopalakrishna, University of Toronto
