The PAPM with Heterogeneous Preferences and Expectations

This Draft: 10/2/2019 Initial Draft: 2/6/2019

Thomas Idzorek | Paul D. Kaplan | Roger G. Ibbotson

Abstract

The Popularity Asset Pricing Model (PAPM) has similar assumptions to the Capital Asset Pricing Model (CAPM), but different conclusions. In the CAPM, the expected excess return of each security is proportional to a single market systematic risk (beta), while in the PAPM, the expected excess return of each security is linearly related to multiple risk and non-risk characteristics (exposures). Relaxing the assumption of homogeneous forecasts and allowing for heterogeneous forecasts changes most of the CAPM’s conclusions but none of the PAPM’s conclusions other than introducing another reason that investors hold unique portfolios. With heterogeneous expectations, many investors believe they have skill, but some have more skill than others. These differences in forecasting skill, together with differences in risk and non-risk preferences lead to a variety of different types of market participants. We illustrate the impact of both heterogeneous expectations and popularity preferences on expected returns and portfolios through a series of highly stylized numerical examples. The PAPM with heterogeneous expectations can be viewed as an extension of the CAPM, but it may be more useful to view the CAPM as special case of the PAPM. By incorporating investor preferences and allowing for heterogeneous forecasts, the PAPM takes two major steps towards asset pricing in the real world.