Horizon Bias and the Term Structure of Equity Returns

Abstract

Ample evidence suggests that individuals are overly optimistic about future outcomes. In this paper, we rely on insights from psychology and economics to cast the novel prediction that optimism grows with the forecast horizon. We provide empirical evidence that professional forecasters and individuals exhibit horizon bias for forecasts of a wide variety of macroeconomic variables, in the United States and abroad. We then assess the extent to which horizon bias can help us rationalize the puzzling empirical facts regarding the term structure of equity returns. We start with a simple present value model, which predicts that horizon bias in investors’ beliefs about future cash flows is negatively related to the realized equity term premium. Using analysts’ earnings forecasts, we confirm that, like forecasts of other macroeconomic variables, beliefs about long-term growth are unconditionally more optimistic than beliefs about short-term growth. As the model predicted, we also find that regimes of above-average horizon bias are associated with negative term premia, whereas regimes of low horizon bias are associated with positive term premia. Motivated by theories of belief formation, we additionally show that the effects of horizon bias are amplified in regimes of highly extrapolative beliefs, and that the interaction between horizon bias and extrapolative beliefs generates strong and robust forecasts of next period’s realized equity term premium.

Keywords: term structure of equities, extrapolation, optimism bias