Implicit Extrapolation and the Beliefs Channel of Investment Demand

From Haoyang Liu and Christopher Palmer

In this paper, we document implicit extrapolation in an individual’s investment decision making that exceeds extrapolation in her stated forecasted returns. Perceived past returns predict individual real estate investment decisions even conditional on an individual’s forecasted distribution of home-price growth. Moreover, the total effect of past returns on investment is twice as large when allowing for a direct effect of past returns. We demonstrate that heterogeneous confidence in their own forecasts helps explain why many retail investors rely on past returns over their survey-elicited forecasts when making investment decisions. Survey respondents that rely on past returns more than their surveyed forecasts frequently cite a lack of confidence in other belief factors or extrapolation as their rationale. We conclude that incorporating additional belief factors would help expectation analysts more fully characterize the scope of the beliefs channel of investment demand.

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