Lock-in of Extrapolative Expectations in an Asset Pricing Model

Abstract

This paper examines an agent's choice of forecast method within a standard asset pricing model. To make a conditional forecast, a representative agent may choose one of the following: (1) a rational (or fundamentals-based) forecast that employs knowledge of the stochastic process governing dividends, (2) a constant forecast based on a simple long-run average of the forecast variable, or (3) a time-varying forecast that extrapolates from the last observation of the forecast variable. I show that a representative agent who is concerned about minimizing forecast errors may inadvertently become locked-in to an extrapolative forecast. In particular, the initial use of extrapolation alters the law of motion of the forecast variable so that the agent perceives no accuracy gain from switching to one of the alternative forecast methods. Under extrapolative expectations, the model can generate excess volatility of stock prices, time-varying volatility of returns, long-horizon predictability of returns, bubbles driven by optimism about the future, and sharp downward movements in stock prices that resemble market crashes. All of these features appear to be present in long-run U.S. stock market data.