Market psychology and financial anomalies - The role of self-fulfilling prophecies

This paper constructs a simple dynamic asset-pricing model where asset prices are influenced by investors' self-fulfilling prophecies. A class of solution processes is analysed, that jointly reproduces two major financial anomalies, namely, the excess volatility of asset prices and the predictability of asset returns. Since these phenomena do not rely on the irrationality of investors' expectations, the model questions the traditional divide between the Efficient Market Hypothesis on the one hand, and the idea that arbitrary beliefs may have an autonomous influence on asset prices, on the other.