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Taking a Disciplined Look at Irrational Investors | Yale Insights

The idea that might be most important about how we form beliefs is overextrapolation. It’s just saying that when we form beliefs about the future, we put too much weight on the recent past. If the recent returns on an asset have been good, we’re too quick to think that the future returns will be good. If they’ve been bad, we’re too quick to think they will continue to be bad.[…] this simple idea can shed light on a lot of key puzzles. One of them is excess volatility—the finding that, historically, the stock market has moved around more than can be explained by simple, rational models of investor behavior.[…]Overextrapolation may also explain bubbles. I’ve also done work trying to understand where overextrapolation comes from. I argued, in one of my first papers, that an idea of Kahneman and Tversky’s called representativeness may be an important driver of overextrapolation. When we see a good economic data point, we leap to the conclusion that it represents a positive trend. Representativeness is a possible source of this overreaction in financial markets.

#markets #stocks #overextrapolation - insights.som.yale.edu

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