untrained in finance) a time series of stock prices and ask them to trade at the
prevailing price. After the subjects trade, the next realization of price ap-
pears, and they can trade again. Trades do not affect prices: subjects trade
with a time series rather than with each other. Stock prices are rescaled real
stock prices taken from the financial press, and sometimes modified by the
introduction of trends.
Andreassen and Kraus’s basic findings are as follows. Subjects generally
“track prices,” that is, sell when prices rise and buy when prices fall, even
when the series they are offered is a random walk. This is the fairly univer-
sal mode of behavior, which is consistent with underreaction to news in
markets. However, when subjects are given a series of data with an ostensi-
ble trend, they reduce tracking, that is, they trade less in response to price
movements. It is not clear from Andreassen and Kraus’s results whether
subjects actually switch from bucking trends to chasing them, although
their findings certainly suggest it.
De Bondt (1993) nicely complements Andreassen and Kraus’s findings.
Using a combination of classroom experiments and investor surveys, De
Bondt finds strong evidence that people extrapolate past trends. In one
case, he asks subjects to forecast future stock price levels after showing
them past stock prices over unnamed periods. He also analyzes a sample of
regular forecasts of the Dow Jones Index from a survey of members of the
American Association of Individual Investors. In both cases, the forecasted
change in price level is higher following a series of previous price increases
than following price decreases, suggesting that investors indeed chase
trends once they think they see them.
4.A Model of Investor Sentiment
4.1. Informal Description of the ModelThe model we present in this section attempts to capture the empirical evi-
dence summarized in section 2 using the ideas from psychology discussed in
section 3. We consider a model with a representative, risk-neutral investor
with discount rate δ. We can think of this investor’s beliefs as reflecting the
“consensus,” even if different investors have different beliefs. There is only
one security, which pays out 100 percent of its earnings as dividends; in this
context, the equilibrium price of the security is equal to the net present
value of future earnings, as forecasted by the representative investor. In
contrast to models with heterogeneous agents, there is no information in
prices over and above the information already contained in earnings.
Given the assumptions of risk-neutrality and a constant discount rate, re-
turns are unpredictable if the investor knows the correct process followed
by the earnings stream, a fact first established by Samuelson (1965). If our
model is to generate the kind of predictability in returns documented in the
A MODEL OF INVESTOR SENTIMENT 433