6 - Representativeness and Heterogeneous Beliefs Among Individual Investors, Financial Executives, and Academics

Abstract

This chapter focuses on individual investors, academics, and corporate financial executives. Different distributions give rise to different shapes of the SDF. Individual investors forecast future returns by engaging in trend following and predicting continuation. In this respect they display hot hand fallacy. Moreover, there is significant heterogeneity among forecasts, and the degree of heterogeneity rose as the bull market of the 1990s turned into a bear market during the early 2000s. As a group, academic financial economists also appear to engage in trend extrapolation, at least in respect to their forecasts of the equity premium. Notably, they too exhibit considerable heterogeneity in their forecasts. Notably, during the late 1990s, proponents of traditional asset pricing appeared to hold very different views about the future equity premium than proponents of behavioral finance. However, as the bull market came to an end, the forecasts of traditional economists moved in the direction of their behavioral colleagues. Corporate financial executives also engage in trend following, and their volatility expectations are negatively related to past returns. Notably, executives underestimated market volatility.