Erik Eyster and Michele Piccione

Published 1 December 2011

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We model a competitive market where risk-neutral traders trade one risk-free and one risky asset with limited short-selling of the risky asset. Traders use incomplete theories that give statistically correct beliefs about the market price of the risky asset next period conditional upon information contained in their theories this period; they neither condition upon information outside of their theories nor upon current market prices. The more theories are present in the market, the higher is the equilibrium price of the risky asset, which exceeds the most optimistic trader's expectation of its present-discounted value. When the dividend paid by the risky asset is sufficiently persistent, low asset prices are more volatile than high asset prices. Investors with more complete theories do not necessarily earn higher returns than those with less complete theories, who can earn more than the risk-free rate, despite perfect competition.