A article in the recent AEJ:Macro:
Learning about Risk and Return: A Simple Model of Bubbles and Crashes
William A. Branch and George W. Evans
This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles, and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.
While I believe the basic premise of the argument is sound, I have to ask: have you ever run a least-squares regression in your head? I haven’t….
If not time-discounted least squares, what is the best model of how investors form opinions?