If all investors had identical expectations,
A) Trading volume in financial markets would be very small. However, the trading volumes of many markets are
huge.
B) All valuations of the shares of a company should coincide. However, there are huge differences in stock
valuations (analysts, investment banks, consultants, financial companies …)
C) The return required for the shares of a company should be identical in all valuations.
D) The expected cash flows of the shares of a company should be identical every year in all valuations.
Since our world is not characterized by any of the four above characteristics, how can one even insinuate the
hypothesis of homogeneous expectations?
My thoughts:
1. I think that the models developed by financial economists have some value, unlike those of Keynesian macroeconomists.
2. However, the fiction of the “representative investor” is problematic for some of the reasons that the fiction of the “representative agent” is problematic in mainstream macro.
3. Economists tend to assume that the conflict between financial practitioners and financial economists should be resolved in favor of economists. To some extent, this has happened, as index funds and Black-Scholes option pricing became important in practice. But as Fernandez points out, financial practice still differs sharply from what models say that it ought to be, and the economists seem to be unwilling to explore why this is the case.
Clear something up for me, plz. If two people trade a stock, from a finance perspective that is a change, but from an economics perspective someone still holds the asset.
So, things like the national debt when people say “we owe it to ourselves,” it is sort of true, but also very significantly false.
Loosely, I’d say that assumptions of representative investors or homogeneous expectations are *sufficient*, not necessary, conditions in academic finance. We teach it because it is a simpler path to showing the results and methods, and we know that these results and methods remain valid if we relax the assumptions (but it’s a lot harder to show–consider Magill and Quinzii’s text (1996)).
So in a sense Fernandez is attacking a straw man. But he’s right that there is an uncomfortable friction, consider the classic No-trade theorem of Milgrom and Stokey (1982).