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Diagnostic Expectations and Stock Returns

Pedro Bordalo, Nicola Gennaioli (), Rafael La Porta () and Andrei Shleifer

No 23863, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We revisit La Porta’s (1996) finding that returns on stocks with the most optimistic analyst long term earnings growth forecasts are substantially lower than those for stocks with the most pessimistic forecasts. We document that this finding still holds, and present several further facts about the joint dynamics of fundamentals, expectations, and returns for these portfolios. We explain these facts using a new model of belief formation based on a portable formalization of the representativeness heuristic. In this model, analysts forecast future fundamentals from the history of earnings growth, but they over-react to news by exaggerating the probability of states that have become objectively more likely. Intuitively, fast earnings growth predicts future Googles but not as many as analysts believe. We test predictions that distinguish this mechanism from both Bayesian learning and adaptive expectations, and find supportive evidence. A calibration of the model offers a satisfactory account of the key patterns in fundamentals, expectations, and returns.

JEL-codes: D03 D84 G02 G12 (search for similar items in EconPapers)
Date: 2017-09
Note: AP
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Published as PEDRO BORDALO & NICOLA GENNAIOLI & RAFAEL LA PORTA & ANDREI SHLEIFER, 2019. "Diagnostic Expectations and Stock Returns," The Journal of Finance, vol 74(6), pages 2839-2874.

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