The Self-Fulfilling Prophecy of Popular Asset Pricing Models

Volume 14, Number 1, 2016
Bradford Cornell and Jason Hsu

The assumption that asset prices are determined by the efforts of end investors to maximize intertemporal utility supports a pricing theory that is both elegant and intuitive. Unfortunately, the assumption is counterfactual. End investors, with few exceptions, lack the capacity to behave in a fashion consistent with the theory. More to the point, they don’t try. Instead, they delegate investment decision-making. Thus, it is important to understand the investment management ecosystem. Is it a simple pass-through mechanism? We do not believe so and argue, instead, that the lack of alignment implies the cross-section of asset returns is significantly influenced by active money managers and deviates from the predictions of the consumption-based model. Using a simple thought experiment, we demonstrate that the widely adopted discounted cash flow model is likely both to drive prices and to determine the cross-section of average returns. This leads to a self-fulfilling feedback loop in which once an asset pricing model is adopted by active managers as a means of estimating the discount rate, it becomes a determinant of expected returns.