Expectations of Returns and Expected Returns

by Robin Greenwood & Andrei Shleifer

Overview — Much of modern asset pricing seeks to explain changes in stock market valuations using theories of investors' time-varying required returns. Although researchers have achieved considerable progress in developing proxies for expected returns, an important but often overlooked test of these theories is whether investors' expectations line up with these proxies. This paper shows that they do not. Key concepts include:

Survey measures of investor expectations are not meaningless noise, but rather reflections of widely shared beliefs about future market returns, which tend to be extrapolative in nature.
Future models of stock market fluctuations should embrace the large fraction of investors whose expectations are extrapolative.

Author Abstract

We analyze time-series of investor expectations of future stock market returns from five data sources between 1963 and 2011. All five 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.