| Abstract: |
Survey evidence suggests that many investors form beliefs about future stock
market returns by extrapolating past returns: they expect the stock market to
perform well (poorly) in the near future if it performed well (poorly) in the
recent past. Such beliefs are hard to reconcile with existing models of the
aggregate stock market. We study a consumption-based asset pricing model in
which some investors form beliefs about future price changes in the stock
market by extrapolating past price changes, while other investors hold fully
rational beliefs. We find that the model captures many features of actual
prices and returns, but is also consistent with the survey evidence on
investor expectations. This suggests that the survey evidence does not need to
be seen as an inconvenient obstacle to understanding the stock market; on the
contrary, it is consistent with the facts about prices and returns, and may be
the key to understanding them. |