Investor extrapolation and expected returns

This paper takes a new approach to examine whether investors extrapolate from past returns to form expectations about future stock returns. Unlike prior research that relies on experiments or surveys to derive investors’ expectations, we estimate expected returns directly from stock prices, the book value of equity, and analyst earnings forecasts. We find that the expected returns are positively related to both past market returns and past stock returns. However, investors’ expectations seem to be overoptimistic (overpessimistic) for stocks that had extremely high (low) returns in the previous year. Furthermore, we find that investors’ expectations about future earnings growth rates are also positively related to past growth rates. The results remain robust after we control for analyst optimism and measures of risk. Taken together, our results are consistent with the findings that investors extrapolate from past stock returns and past earnings growth rates.