Divergent Expectations

Abstract

Investors who have the same information and interpret it differently are said to have divergent (as distinct from homogeneous) expectations. Financial economists generally frown on the divergent expectations assumption, even though it is critically important in describing reality. The idea of divergent expectations paves the way to understanding price and quantity discovery as major functions of a marketplace, and goes to the heart of important questions: What drives trading, and why does market structure matter? Many issues concerning market structure and market structure regulation should be analyzed in a divergent or heterogeneous expectations context, which has implications for market participants and public policy. We benefit from paying more attention to how asset managers behave.