The Danger of Assuming Homogeneous Expectations

The capital asset pricing model, the Black-Scholes option valuation model, and many other economic models rely on the assumption of homogeneous expectations. What are the effects of heterogeneous expectations on price determination? Are the homogeneous expectations models “approximately” correct? We compare stock price dynamics in models with homogeneous and heterogeneous expectations. Heterogeneous expectations appear to play a crucial role in risky asset price determination. When homogeneous expectations are assumed, unacceptable market inefficiencies are observed. The introduction of even a small degree of diversity of expectations changes the dynamics dramatically, and the result is a much more realistic market. These findings make one wonder how far the equilibrium prices of the CAPM and Black–Scholes model are from the true values in markets with heterogeneous expectations.