Preference Evolution and Asset Prices

Project Start:06/2014
Researchers:Giuliano Curatola, Ilya Dergunov
Category: Macro Finance
Funded by:LOEWE

Topic and Objectives

This project introduces a novel reason (i.e. preference evolution) for time variation in asset prices that offers a possible explanation for several stylized facts of financial markets such as under-performance and local biases of investors' portfolios and several regularities of stock returns such a time variation, the value effect and stochastic volatility. Traditional economic literature assumes that individuals' preferences are exogenously given and remain unchanged over time. However, as our everyday life suggests, preferences and tastes may change for a number of reasons: circumstantial changes, age-related issues, social interaction, acquisition of new information or sensitivity to fashion trends. As a result, the choice among different consumption goods depends on the evolution of consumers' taste over time.

In this project, it is assumed that consumers' preferences evolve over time as a product of social interaction among individuals. Social interaction occurs because investors are sensitive to fashion cycles of consumption goods that, in turn, depend on individuals' optimal consumption choices. The dynamics of preference evolution described above is incorporated into an otherwise standard Lucas-type exchange economy, and the implications of time variation in preferences is characterized for investors' trading strategy, asset price and return dynamics. The economy is populated with two types of agents, conformist and anti-conformist. The preferences of conformist investors evolve in favor of fashionable consumption goods, while the preferences of anti-conformist investors evolve in favor of out-of-fashion consumption goods.

Key Findings

The interaction of preference evolution and standard market forces of pure-exchange economies generates the following dynamics of trading strategies and stock returns.

  • First, the portfolio of conformist investors is biased toward companies (or sectors) that produce fashionable goods while the portfolio of anti-conformist investors is biased toward companies (or sectors) that produce out-of-fashion goods. This implies that investors with time-varying preferences may end up with a portfolio of socially desirable but poorly performing stocks.
  • Second, preference evolution implies that stock return and asset prices are both time-varying, therefore assets with high price-dividend ratio may have high expected returns or low expected returns depending on cash-flow characteristics and the percentage of conformist/anti-conformist investors in the economy.
  • Stock market volatility is also time-varying and depends on the perception of consumption risk induced by conformist and anti-conformist behavior. Conformist investors find it difficult to imitate other investors when one of the consumption goods becomes extremely popular and all investors desire to buy that good. Therefore, when the majority of investors in the economy are conformist, the return volatility is high when a consumption good becomes more popular relatively to the others. Differently, anti-conformist investors find it difficult to differentiate themselves from others when the consumption goods in the economy have similar popularity. Therefore, when the majority of investors are anti-conformist, the return volatility is high when the consumption goods are equally popular among investors.

Related Published Papers

Author/sTitleYearProgram AreaKeywords
Giuliano CuratolaPortfolio Choice and Asset Prices when Preferences are Interdependent
Journal of Economic Behavior & Organization
2017 Macro Finance Asset pricing; General equilibrium; heterogeneous investors; interdependent preferences; portfolio choice

Related Working Papers

No.Author/sTitleYearProgram AreaKeywords
128Giuliano CuratolaPreference Evolution and the Dynamics of Capital Markets2016 Macro Finance Asset pricing, general equilibrium, heterogeneous investors, interdependent preferences, portfolio choice