Perfect Forecasting , Behavioral Heterogeneities , and Asset Prices ∗

This survey reviews a dynamic multi-asset framework in which heterogeneous agents with multi-period planning horizons interact. This framework distinguishes between temporary equilibrium maps describing the basic market mechanism of an asset market, forecasting rules which model the way in which expectations are formed, and a model for exogenous random perturbations. Perfect forecasting rules which provide correct forecasts for first and second moments of future prices are introduced. Based on these perfect forecasting rules, fundamental concepts of the traditional CAPM are extended to a setting in which beliefs are not homogeneous. We review a multi-fund separation theorem and introduce the notion of a generational portfolio which is held by investors with homogeneous beliefs and identical planning horizons. It is shown that social interaction among consumers may endogenously create risk leading to non-ergodic behavior of asset prices. The stochastic dynamics of asset prices, beliefs, portfolio holdings, and market shares are illustrated with numerical simulations. Acknowledgment. This work is a survey prepared for a chapter in the forthcoming Handbook of Finance, edited by Klaus Reiner Schenk-Hoppé and Thorsten Hens. I would like to thank Marten Hillebrand, Ulrich Horst, Gauthier Lanot, Klaus Reiner Schenk-Hoppé, Tim Worrall, and Volker Böhm for very valuable comments and discussions. All errors are mine.