Portfolio Analysis and Zero-Beta CAPM with Heterogeneous Beliefs

With the standard mean variance framework, by assuming heterogeneity and bounded rationality of investors, this paper examines their impact on the market equilibrium and implications to the portfolio analysis. By constructing a market consensus belief, we establish market equilibrium prices of risky assets and show that the standard Black’s zero-beta CAPM under homogeneous beliefs holds under the heterogeneous belief. We demonstrate that the biased belief (from the market consensus belief) of investors makes their optimal portfolio not necessarily locate on the market mean-variance frontier. We show that the traditional geometric relation of the mean variance frontiers with and without the riskless asset under the homogeneous beliefs does not hold under the heterogeneous beliefs. The results shed light on the risk premium puzzle, Miller’s hypothesis, the lower market performance when the access to the riskfree asset is impossible, and the empirical finding that managed funds under-perform comparing to the market indices on average.