Learning from Prices and the Dispersion in Beliefs

The article develops a dynamic model that nests the rational expectations (RE) and differences of opinion (DO) approaches to study how investors use prices to update their valuations. When investors condition on prices (RE), investor disagreement is related positively to expected returns, return volatility, and market beta, but negatively to return autocorrelation. When investors do not use prices (DO), these relations are reversed. Tests of these predictions on the cross-section of stocks using analyst forecast dispersion and volume as proxies for disagreement provide empirical evidence that is consistent with investors using prices on average. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.