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Beyond the Crashes: An In-Depth Look at Preferences and Beliefs Shaped by Market Downturns

Job Market Paper

This paper examines the influence of stock market downturn experiences on investors' risk preferences and beliefs using a novel information-theoretic approach. Downturn experiences tend to ``filter out'' individuals with low risk tolerance, thus the remaining stock market participants who have endured market downturns are generally more risk-tolerant than those who have not. These experiences also induce a pessimisic outlook on the market returns, and investors with such experiences require higher returns during economic downturns. Notably, investors with bad stock market experiences reduce their stock allocation due to their pessimisic beliefs, not their risk preferences. 

Recovering Heterogeneous Beliefs and Preferences from Asset Prices

With Anisha Ghosh and Arthur Korteweg

Revise and resubmit at Journal of Finance

We propose a novel information-theoretic approach to separately identify the risk preferences and beliefs of different types of financial market investors. Investors who optimally allocate most of their wealth to large market capitalization stocks are risk averse and believe that the aggregate stock market return, and its Sharpe ratio, is strongly countercyclical. Investors in value stocks have similar risk preferences and beliefs to the large-cap investor. In contrast, investors in momentum and small-growth stocks have procyclical beliefs. Momentum investors are more risk-averse than the large-cap investor, and small-growth investors are less risk-averse. Our findings can reconcile the procyclical expected market returns found in investor survey data with the countercyclical expected returns implied by rational expectations models.

What Do Surveys Imply About Investors' Preferences?

Developed from second-year paper

This paper proposes a novel approach to recover investors' preferences in a model-free setting. Approximating investors' beliefs by recent survey data, the risk preferences can be recovered by maximizing the smoothed empirical likelihood without function-form assumptions. The resulting investors' preferences display diminishing marginal utility when the uncertainty of the market is low. However, in economic crises, the patterns of the preferences are U-shaped. We also prove that the conventional linear factor models fail to capture the U-shaped pattern.

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