The Expectations Clock: A Unified Model for Over- and Under-Reaction

Abstract

The expectations clock illustrates how expectations of future performance are driven by human biases tied to current and past changes in performance. Performance changes over time, so expectations may cycle between improving and declining and high and low. Expectations may be highest when current and past changes in performance are above average, and may be lowest when current and past changes in performance are below average. The clock is a model of over- and under-reaction, and hence, of reversion and momentum. Over- and under-reaction refer to reactions to negative circumstances. Depending on initial expectations, negative events may be disregarded or accentuated in the decision-making process. When expectations are high, negative events may be ignored, resulting in under-reaction and short-term momentum, and when expectations are low, negative circumstances may be over-emphasized, causing over-reaction and long-term reversion.

Keywords: behavioral finance, efficient markets, expectations, expectation, reversion, momentum, overreaction, underreaction, over-reaction, under-reaction, cycles

JEL Classification: G10, G12, G14, G30