An Equilibrium Model with Buy and Hold Investors

Abstract

This is the first study to analyze the effects of buy and hold investors on equilibrium security price dynamics. The empirical literature suggests that many investors follow buy and hold strategies by rarely changing asset and flow allocations due to information costs or other frictions. Similar strategies are documented for institutional investors. Such strategies reduce market liquidity and amplifies the volatility of risky assets. A buy and hold investor effectively faces an incomplete market and differs in her pricing of risk from a dynamic asset allocator. The equilibrium is solved through the construction of a representative agent with state-dependent utility. The fraction of the stock held by the buy and hold investor emerges as an additional state variable. Characterizations of equilibrium quantities are given analytically as functions of the state variables. In contrast to most previous literature, stock return volatility is solved endogenously in this paper. A simple calibration of our model shows that the economy with buy and hold investors can simultaneously produce a low interest rate and a high Sharpe ratio for the stock. In addition, the buy and hold economy can deliver stock return volatility more than twice that in the limited participation economy, because the stock price is more sensitive to dividend shocks in the buy and hold economy. Moreover, the buy and hold economy achieves this while keeping interest rate volatility at reasonably low levels at the same time.