Forecasting returns instead of prices exacerbates financial bubbles

Abstract

AbstractExpectations of future returns are pivotal for investors’ trading decisions, and are therefore an important determinant of the evolution of actual returns. Evidence from individual choice experiments with exogenously given time series of returns suggests that subjects’ return forecasts are substantially affected by how they are elicited and by the format in which subjects receive information about past asset performance. In order to understand the impact of these effects found at the individual level on market dynamics, we consider a learning to forecast experiment where prices and returns are endogenously determined and depend directly upon subjects’ forecasts. We vary both the variable (prices or returns) subjects observe and the variable (prices or returns) they have to forecast, with the same underlying data generating process for each treatment. Although there is no significant effect of the presentation format of past information, we do find that markets are significantly more unstable when subjects have to forecast returns instead of prices. Our results therefore show that the elicitation format may exacerbate, or even create, bubbles and crashes in financial markets.