Adaptive expectations versus rational expectations: Evidence from the lab

Abstract

The aim of the present work is to shed light on the extensive debate about expectations in financial markets. We analyze the behaviors of subjects in an experimental environment in which it is possible to observe expectations directly, since the sole task of each player is to predict the future price of an asset. We investigate the mechanism of expectation formation in two different contexts: first, where the fundamental value is constant; second, where the fundamental price increases over repetitions. First of all, we look at whether there is a convergence to the rational equilibrium even if agents have adaptive expectations, according to the main results of Palestrini and Gallegati (2015). Moreover, we concentrate on the accuracy of aggregate forecasts compared with individual forecasts. We find that there is collective rationality instead of individual rationality. In the context of an increasing fundamental value, contrary to theoretical predictions, players are able to capture the trend, but underestimate that value. This implies that there is no full convergence to the rational expectations equilibrium if all agents make their forecasts according to an adaptive scheme.