Overreaction in Expectations: Evidence and Theory

Abstract

We investigate biases in expectations across different settings through a large-scale randomized experiment where participants forecast stable stochastic processes. The experiment allows us to control forecasters’ information sets as well as the data-generating process, so we can cleanly measure biases in beliefs. We report three facts. First, forecasts display significant overreaction to the most recent observation. Second, overreaction is stronger for less persistent processes. Third, overreaction is also stronger for longer forecast horizons. We develop a tractable model of expectations formation with costly processing of past information, which closely fits the empirical facts. We also perform additional experiments to test the mechanism of the model.