Expectation formation in financial markets: Heterogeneity and sentiment

Bart Frijns, Thanh Huynh and Remco C.J. Zwinkels

Journal of Economic Dynamics and Control, 2025, vol. 177, issue C

Abstract: We set up an endowment based asset pricing model in which agents have heterogeneous expectations about future price levels. Expectations are a function of fundamentals or trends, both interacted with sentiment. Agents are able to switch between expectation formation functions based on past performance combined with sentiment. Estimation results on the S&P500 index as well as its constituents reveal that there is heterogeneity between agents, with substantial switching between groups. We find that sentiment has both a direct and an indirect effect on expectations. Specifically, heterogeneity between groups is increasing in sentiment, and higher sentiment reduces the frequency of switching between functions. Our results imply that the true expectation formation process is a dynamic process based on multiple information sources.

Keywords: Expectation formation; Investor sentiment; Heterogeneity (search for similar items in EconPapers)
JEL-codes: G12 G14 G41 (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:177:y:2025:i:c:s0165188925000995

DOI: 10.1016/j.jedc.2025.105133

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