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Interactions between Domestic and Foreign Investment

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  • Robert E. Lipsey
  • Guy V.G. Stevens

Abstract

We present a model of portfolio allocation by noise traders who form incorrect expectations about the variance of the return distribution of a particular asset. We show that for many types of misperceptions, as long as such noise traders do not affect prices, they earn higher expected returns than do rational investors with similar degrees of risk aversion. Moreover, many such noise traders survive and dominate the market in terms of wealth in the long run, in the sense that the probability that noise traders will eventually have a high share of the economy's wealth is arbitrarily close to one. Noise traders come to dominate the market despite the fact that they take excessive risk that skews the distribution of their long run wealth and despite their excessive consumption. We conclude that the theoretical case against the long run viability of noise traders is by no means as clear cut as is commonly supposed.

Suggested Citation

  • Robert E. Lipsey & Guy V.G. Stevens, 1988. "Interactions between Domestic and Foreign Investment," NBER Working Papers 2714, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2714
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    References listed on IDEAS

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    1. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-1286, September.
    2. Magnus Blomstrom & Robert E. Lipsey & Ksenia Kulchycky, 1988. "U.S. and Swedish Direct Investment and Exports," NBER Chapters, in: Trade Policy Issues and Empirical Analysis, pages 257-302, National Bureau of Economic Research, Inc.
    3. Guy V. G. Stevens, 1986. "Internal funds and the investment functions: exploring the theoretical justification of some empirical results," Special Studies Papers 199, Board of Governors of the Federal Reserve System (U.S.).
    4. Alan K. Severn, 1972. "Investment and Financial Behavior of American Direct Investors in Manufacturing," NBER Chapters, in: International Mobility and Movement of Capital, pages 367-396, National Bureau of Economic Research, Inc.
    5. Kravis, Irving B. & Lipsey, Robert E., 1978. "Price behavior in the light of balance of payments theories," Journal of International Economics, Elsevier, vol. 8(2), pages 193-246, May.
    6. Peter M. Garber & Robert G. King, 1983. "Deep Structral Excavation? A Critique of Euler Equation Methods," NBER Technical Working Papers 0031, National Bureau of Economic Research, Inc.
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