Unbiased Disagreement in Financial Markets, Waves of Pessimism and the Risk-Return Trade-off*

Abstract

Can investors with irrational beliefs be neglected as long as they are rational on average ? Do their trades cancel out with no consequences on prices, as implicitly assumed by traditional models? We consider a model with irrational investors, who are rational on average. We obtain waves of pessimism and optimism that lead to countercyclical market prices of risk and procyclical risk-free rates. The variance of the state price density is greatly increased. The long run risk-return relation is modified; in particular, the long run market price of risk might be higher than both the instantaneous and the rational ones.