Abstract: We develop a dynamic model of index investing that can reconcile key cross-sectional differences between index and non-index stocks. In our model, investors with extrapolative expectations create sentiment, and index investing spills the sentiment on an index stock to all other index stocks. Primarily due to this spillover mechanism, we find that when index investors are mostly extrapolators, all consistent with empirical evidence, index stocks have higher and more volatile prices, comove more with other index stocks, exhibit stronger negative price autocorrelation, and have higher trading volume than comparable non-index stocks. Our model also reconciles the recently observed “disappearing index effect” and delivers novel implications on the flow-performance relation for index funds, the response of investor portfolios to their subjective beliefs, and the welfare costs of index investing.
Abstract: We uncover financial professionals’ mental models—the narratives they use to explain their subjective beliefs. Using 82,000 equity reports, we prompt large language models (LLMs) to extract 3.5 million narratives, each combining a topic, valuation channel, sentiment, and time outlook. To validate the reliability of our output, we introduce a multi-step LLM-based approach and new diagnostic tools. We establish three sets of findings. First, narratives are centered around a limited set of topics, primarily focused on top-line items, with variation in topic focus over time and across industries. Narratives are mostly forward-looking, with three times as many arguments focusing on the future as on the past. Second, differences in topic focus, sentiment, and time outlook across forecasters strongly predict the extent of disagreement in their subjective quantitative forecasts. Lastly, time-series variation in the average narrative’s sentiment and in the average narrative’s focus on top-line items closely track Shiller’s CAPE ratio (ρ = 0.84 and ρ = 0.42), and the cross-sectional variation in narratives predicts key asset pricing patterns. Narratives associated with growth stocks are more optimistic and forward-looking than those for value stocks, consistent with forecasters (mis)perceiving growth stocks as having above-average growth potential. Overall, this paper helps bridge the gap between ‘what forecasters believe’ and ‘why they believe it.’
Abstract: Are belief dynamics or risks and risk attitudes more important for asset pricing? Al-lowing both, I use survey data combined with subjective-belief versions of stochasticdiscount factor (SDF) volatility bounds to shed new light on this classic question. Iestimate lower bounds for the volatility of the SDF attributable to (i) risks relevant forinvestor marginal utility, versus (ii) subjective belief dynamics. The estimates sug-gest that risks, particularly long-term risks, make up at least half of SDF volatility.An example extrapolation model with a modest direct contribution of beliefs to SDFvolatility (about 25%) can account for my estimates. This example also highlights thepotential for a novel mechanism, subjective risk, which is the indirect impact of beliefshave on asset prices through induced marginal utility volatility.
Discussant: Ricardo De la O, University of Southern California
