"Superstitious" Investors *

Abstract

We reconsider the Shiller (1981) volatility puzzle through the lens of a model in which agents believe they can predict dividend growth when in fact they cannot. Besides excess volatility in the time series, the model explains the value premium, and the explanatory power of the value factor. In support of the model, we show that analysts' earnings forecasts align with market valuation and that analysts are far more optimistic about growth stocks than value stocks. Using both survey and price data, we show that the same mechanism can explain the excess returns earned by investing in high-interest rate currencies.

Keywords: Excess volatility, Extrapolative expectations, Rare events, Overconfidence, Carry trade JEL codes: G12, G15, G41

JEL Classification: G12, G15, G41