Just passing this paper along which I missed. Noah Smith mentioned it yesterday on Twitter and it looks pretty interesting. If any fellow nerds have thoughts feel free to use the comments…
X-CAPM: An Extrapolative Capital Asset Pricing Model
Nicholas Barberis, Robin Greenwood,
Lawrence Jin, and Andrei Shleifer
Yale University and Harvard University
Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns: they expect the stock market to
perform well (poorly) in the near future if it performed well (poorly) in the recent past. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by
extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns, but is also consistent with the survey evidence on investor expectations. This suggests that the survey evidence does not need to be seen as an inconvenient obstacle to understanding the stock market; on the contrary, it is consistent with the facts about prices and returns, and may be the key to understanding them.
Read it here.