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Are Long-Horizon Expectations (De-)Stabilizing? Theory and Experiments

Bank of Canada 2019.08.27
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Most models in finance assume that agents make trading plans over the infinite future. We consider instead that they are boundedly rational and may only form forecasts over a limited horizon. We explore how participants in financial markets trading over finite horizons affect the level and the volatility of the price. In our theoretical model, agents with different planning horizons may hold different expectations over those horizons and trade the asset accordingly. We derive testable implications in the lab under various theories of expectation formation over those horizons. Then we design a laboratory experiment to test these theoretical implications against human behaviour. Our experiment confirms most of our theoretical hypotheses. Short-horizon trading favors deviations of the asset price from fundamentals. By contrast, a modest share of long-horizon traders is enough for the price to stabilize around its fundamental value. This is because short-horizon traders tend to coordinate their price forecasts using non-fundamental factors, such as recent price trends, in choosing their trading strategies. Long-horizon traders hold more heterogeneous views about future price developments, which prevents such trend-chasing behaviour.

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