Noted for January 30, 2013
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M.C.K. Precis (Is That a Verb? It Is Now) Greenwood and Shleifer: "Expectations of Returns and Expected Returns"

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Investing: Irrationality, trend-following, and cats: Robin Greenwood and Andrei Shleifer… [argue that] actual people basically do the opposite of what rational expectations models suggest they should do. Mr Greenwood and Mr Shleifer measure investor expectations for the stock market by looking at the results of six separate surveys, as well as the flows into and out of equity mutual funds. They find that all of the surveys are strongly correlated with each other. Unsurprisingly, they also find that there is a strong relationship between equity fund flows and investor optimism… when people expect to stock prices to go up a lot, they buy more shares.

But what determines these expectations? According to rational expectations theory, investors should become increasingly bullish as dividend yields rise (roughly). Yet it turns out that survey respondents are astonishingly bad investors who buy high and sell low:

[The] evidence is inconsistent with the view that expectations of stock market returns reflect the beliefs or requirements of a representative investor in a rational expectations model...Investor expectations tend to be extrapolative: they are positively correlated with past stock market returns, as well as with the level of the stock market (i.e., they are positively correlated with the price-dividend ratio).

Some financial economists dismiss the value of these survey results, even going so far as to say that respondents do not understand what they are being asked. The authors have little sympathy with this view:

Perhaps when investors report high expectations of market returns, they mean high expected growth of fundamentals, in which case their true expectations of market returns are low. This conjecture seems inconsistent with the obvious fact that respondents in the surveys we cover are active investors, and even CFOs, and they are asked directly about their expectations of stock market returns, not changes in fundamentals. The conjecture is also inconsistent with the high correlation between investors’ reported expectations and their actual behavior, as measured by the flows that retail investors direct into mutual funds.

What can we learn from this? As a first approximation, you should avoid trying to time the market… you are probably buying high and selling low, just like everyone else. You would be better off letting a cat manage your money…

Robin Greenwood and Andrei Shleifer: Expectations of Returns and Expected Returns:

We analyze time-series of investor expectations of future stock market returns from six data sources between 1963 and 2011. The six measures of expectations are highly positively correlated with each other, as well as with past stock returns and with the level of the stock market. However, investor expectations are strongly negatively correlated with model-based expected returns. We reconcile the evidence by calibrating a simple behavioral model, in which fundamental traders require a premium to accommodate expectations shocks from extrapolative traders, but markets are not efficient.