Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/282379 
Year of Publication: 
2023
Series/Report no.: 
CESifo Working Paper No. 10691
Publisher: 
Center for Economic Studies and ifo Institute (CESifo), Munich
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 efficiency 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 series 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.
Subjects: 
mental models
return expectations
JEL: 
D83
D84
G11
G12
G41
G51
G53
Document Type: 
Working Paper
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