Diversification Effect of Heterogeneous Beliefs

Abstract

Through a mean-variance (MV) heterogeneous agent models with many risky assets, this paper examines the impact of behavioral heterogeneity on the market equilibrium and MV efficiency. We show that in market equilibrium, though the optimal portfolios of investors under their subjective beliefs are not MV efficient, they can be very close to the MV efficient frontier under the consensus belief. By imposing a mean-preserved spread distribution on the heterogeneous beliefs and conducting a statistical analysis based on Monte Carlo simulations, we show that diversity in the heterogeneous beliefs among investors can improve the Sharpe and Treynor ratios of the market portfolio and the optimal portfolios of investors, leading to a diversification effect of the heterogeneous beliefs.