| Abstract: |
Investors’ return expectations are pivotal in stock markets, but the reasoning
behind these expectations remains a black box for economists. This paper sheds
light on economic agents’ mental models – their subjective understanding – of
the stock market, drawing on surveys with the US general population, US retail
investors, US financial professionals, and academic experts. Respondents make
return forecasts in scenarios describing stale news about the future earnings
streams of companies, and we collect rich data on respondents’ reasoning. We
document three main results. First, inference from stale news is rare among
academic experts but common among households and financial professionals, who
believe that stale good news lead to persistently higher expected returns in
the future. Second, while experts refer to the notion of market effi-ciency to
explain their forecasts, households and financial professionals reveal a
neglect of equilibrium forces. They naively equate higher future earnings with
higher future returns, neglecting the offsetting effect of endogenous price
adjustments. Third, a se-ries of experimental interventions demonstrate that
these naive forecasts do not result from inattention to trading or price
responses but reflect a gap in respondents’ mental models – a fundamental
unfamiliarity with the concept of equilibrium. |