The Coherence Side of Rationality: Rules of Thumb, Narrow Bracketing, and Managerial Incoherence in Corporate Forecasts

Abstract

We develop a theory of forecast coherence in firm production and we use it to evaluate the rules of thumb managerial textbooks have proposed to help firms make rational forecasts of multiple firm variables, including output and inputs growth. A normative version of our model yields a benchmark of first-best coherent forecasts. A positive version of our model, where agents observe noisy signals
of inputs and output, rationalizes some rules of thumb as second-best optimal responses to noisy signals, and yields testable predictions linking incoherence, rules of thumb, and corporate performance. In our theory, incoherence arises from 'narrow thinking', namely, intra-personal frictions in coordinating forecasts of multiple contemporaneous variables, and operates via the use of rules of thumb. Consistent with our model, using the Duke Survey of top executives of large US corporations we find that firm performance correlates negatively with incoherence, being lowest for firms whose CFOs provide "narrow bracketing" forecasts—projecting past capital growth into the future while ignoring output and labor. Our results imply that about one-half of CFOs make incoherent forecasts of their own firm’s output and inputs' growth.

Keywords: Coherence, Rules of Thumb, Narrow Bracketing, Firm Expectations

JEL Classification: D84, D22, L2, M2, G32