Optimal Portfolio Choice under Heterogeneous Beliefs

This paper analyzes how an investor who is convinced that he can``beat the market' should behave when the equilibrium priceprocess is endogenous. The investor's optimal portfolio is shownto consist of three components: (1) a tangency portfolio, (2) ahedge portfolio against changes in the market's valuation ofsecurities, and (3) a hedging position against changes in thedivergence between the investor's and the market's beliefs. Thesign and magnitude of this third component will depend on investorpreferences and on the divergence in the investor's and themarket's quality of information. A numerical example illustratesthat the effect of heterogeneous beliefs on optimal portfolioallocations can be significant.