Instability of Financial Markets and Preference Heterogeneity

Abstract EN

This paper presents a simple rational expectations model of intertemporal asset pricing relating instability of stock return characteristics to heterogeneity in investor preferences.

Heterogeneity is likely to generate declining aggregate relative risk aversion.

This leads to variability in expected asset returns, volatility, and autocorrelation.

The stronger this variability is, the more heterogeneous preferences are, implying more instability of financial markets.

Stock market crashes may be observed if relative risk aversion differs strongly across investors.