Prices and Portfolio Choices in Financial Markets: Theory, Econometrics, Experiments

Authors

  • Peter Bossaerts,

    1. Division of the Humanities and Social Sciences, California Institute of Technology, Baxter Hall, 1200 E. California Blvd., Pasadena, CA 91125, U.S.A., and Center for Economic Policy Research, London, U.K., and Swiss Finance Institute, Zurich, Switzerland; pbs@rioja.caltech.edu
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  • Charles Plott,

    1. Division of the Humanities and Social Sciences, California Institute of Technology, Baxter Hall, 1200 E. California Blvd., Pasadena, CA 91125, U.S.A.; cplott@hss.caltech.edu
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  • William R. Zame

    1. Dept. of Economics, University of California, Los Angeles, Bunche Hall, Los Angeles, CA 90095, U.S.A., and California Institute of Technology, Pasadena, CA 91125, U.S.A.; zame@econ.ucla.edu
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    • We thank seminar audiences at the Atlanta Finance Forum, Bachelier Finance Society International Congress, CMU, CEPR, CIDE, Erasmus University, Harvard University, Insead, IDEI, London Business School, NBER, RFS Conference on Behavioral and Experimental Finance, Rice University, SWET, UC Berkeley, UCLA, UC Riverside, University of Chicago GSB, University of Copenhagen, USC, and University of Texas (Austin) for comments, and the R. G. Jenkins Family Fund, the National Science Foundation, the Caltech Laboratory for Experimental Economics and Political Science, the John Simon Guggenheim Foundation, the Social and Information Sciences Laboratory at Caltech, the UCLA Academic Senate Commitee on Research, and the Swiss Finance Institute for financial support. Opinions, findings, conclusions, and recommendations expressed in this material are those of the authors and do not necessarily reflect the views of any funding agency.


Abstract

Many tests of asset-pricing models address only the pricing predictions, but these pricing predictions rest on portfolio choice predictions that seem obviously wrong. This paper suggests a new approach to asset pricing and portfolio choices based on unobserved heterogeneity. This approach yields the standard pricing conclusions of classical models but is consistent with very different portfolio choices. Novel econometric tests link the price and portfolio predictions and take into account the general equilibrium effects of sample-size bias. This paper works through the approach in detail for the case of the classical capital asset pricing model (CAPM), producing a model called CAPM+ε. When these econometric tests are applied to data generated by large-scale laboratory asset markets that reveal both prices and portfolio choices, CAPM+εis not rejected.

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