Horizon Bias and the Term Structure of Equity Returns

Abstract

Ample evidence suggests that individuals are overly optimistic about future outcomes. But does the length of a particular forecast horizon affect optimism levels? In this paper, we extend Brunnermeier and Parker’s (2005) optimal expectations framework to a multi-period model, which casts the novel prediction that optimism grows with the forecast horizon. We provide empirical evidence that forecasters exhibit horizon bias when making predictions about a wide variety of macroeconomic variables, in the United States and abroad. Using analysts’ earnings forecasts, we also confirm the presence of a horizon bias in the stock market. We then argue that the horizon bias can help explain the puzzling time-series variation in the term structure of equity returns. Consistent with the intuition from a simple present-value model, we find that periods of above-average horizon bias are associated with negative term premia, whereas periods of below average horizon bias are associated with positive term premia. Finally, we explore our model’s implication
that the horizon bias should increase with the skewness of future outcomes. We confirm that the level of horizon bias in the stock market correlates with the market’s implied skewness. We further find that the interaction between horizon bias and skewness generates strong and robust forecasts of future equity term premia.

Keywords: term structure of equities, extrapolation, optimism bias