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Survey Expectations and the Equilibrium Risk-Return Trade Off

Intuition and leading equilibrium models are at odds with the empirical evidence that expected returns are barely related to volatility at the market level. This paper proposes a closed-form general equilibrium model, which connects the investors' expectations of fundamentals with those of market returns, as documented by survey data. Forecasts suggest that investors feature pro-cyclical optimism and hence overestimate the persistence of aggregate risk. In bad times, the forward-looking component of stock volatility offset the transient risk and leads to a weak risk-return relation, in line with survey data about market returns. The model mechanism is robust to many features of financial markets.