Advances in Decision Sciences
Volume 2010 (2010), Article ID 791025, 27 pages
Research Article

Instability of Financial Markets and Preference Heterogeneity

1Department of Economics, University of Konstanz, 78457 Konstanz, Germany
2McKinsey & Company, Inc., Taunustor 2, 60311 Frankfurt/Main, Germany

Received 22 December 2009; Accepted 7 March 2010

Academic Editor: Wing-Keung Wong

Copyright © 2010 Günter Franke and Erik Lüders. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.


This paper presents a simple rational expectations model of intertemporal asset pricing relating instability of stock return characteristics to heterogeneity in investor preferences. Heterogeneity is likely to generate declining aggregate relative risk aversion. This leads to variability in expected asset returns, volatility, and autocorrelation. The stronger this variability is, the more heterogeneous preferences are, implying more instability of financial markets. Stock market crashes may be observed if relative risk aversion differs strongly across investors.