Asset-price expectations.

• Author: Froot, Kenneth A.

Asset-Price Expectations

Most investors know that excess returns on stocks, bonds, and exchange rates are largely unpredictable. Rationally, they realize that if an asset were widely perceived to be cheap, it would not remain cheap for very long. Speculation ensures both that there will be no easy money and that any predictable component of price changes will be dwarfed by the magnitude of the price changes themselves.

With sophisticated statistical methods at their disposal, economists have been busy identifying these predictable components. Although this portion of returns comprises only a tiny fraction of short-horizon price movements, it has become the subject of heated debate. Some economists argue that any portion of returns found to have been predictable must already have been in investors' minds. In other words, they argue that we can learn about investors' expectations by looking at what actually happened to prices. So, for example, if the stock market rises rapidly for several years, they might conclude that the expected return on stocks was very high (but that stocks also must have been very risky).

However, others disagree with this approach. They contend that investors do not think of this portion of returns as predictable but rather that the predictable components are either statistical artifacts or evidence that some investment strategies indeed pay high risk-adjusted returns. Therefore, the alternative view holds that a rapid rise in stock prices tells us little about investor expectations.

One portion of my research has focused on expectations of asset-price changes. In particular I ask: first, how well can one approximate the market's expectation from actual realizations; and, second, to the extent that the approximation is poor, how do expectations behave in fact?

Findings from Survey Data

In order to answer these questions, one needs a new measure of investor expectations. In a number of papers, several coauthors and I have used survey data on asset-price expectations elicited from asset-market participants. These data come from seven independent surveys (five from foreign exchange markets and two from bond markets) conducted across a broad range of sample periods, forecast horizons, and financial instruments. Despite this diversity, several striking facts emerge consistently from these data:

1) The shorter the forecast horizon, the more expectations extrapolate recent price trends. While at short horizons, investors...