Are stock markets really like beauty contests? An asset pricing model with higher order beliefs and its empirical evidence

The goal of this paper is to assess, for the first time, the empirical impact of ”Keynes’ beauty contest”, or ”higher order beliefs”, on asset price volatility. The paper shows that heterogeneous expectations induce higher order beliefs and that asset pricing models with heterogeneous expectations theoretically generate more volatility than rational expectation models. The paper also explains how, with some assumptions on the distribution of public and private information, a model with higher order beliefs can be empirically tested. The model is then applied to American stock market annual data. The results show that a model with higher order beliefs generates a level of volatility in line with the price volatility observed on the market.