Beauty Contests and Iterated Expectations in Asset Markets∗

In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow’s price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information. ∗We thank the editor, Maureen O’Hara and a referee for comments on an earlier draft. We also thank seminar participants at the LSE, the Bank of England, the IMF, Stanford, the accounting theory mini-conference at Chicago GSB, and the Gerzensee finance meetings for their comments. We thank Mehul Kamdar for capable research assistance.