Experiences, expectations, and asset prices

Abstract In models with subjective beliefs, the dynamics of investor beliefs are central to explaining asset price movements. Allowing subjective beliefs to deviate from full-information rational expectations requires a model of how investors form beliefs. I review recent research that explores experience-based belief formation. The experience-based model closely resembles Bayesian updating but allows individuals to overweight data observed during their own lifetimes when forming beliefs about the parameters of the data-generating process. Because individuals of different age learn from different histories, the model predicts heterogeneity between age groups that evolves over time with the path of realized data individuals have experienced, closely mirroring the age-related variation observed in survey microdata. At the aggregate level, experience-based expectations formation can explain asset price dynamics. In the stock market, learning from experience about long-run cash flow growth generates valuation cycles and return predictability. Experience-based formation of long-term inflation expectations can explain secular changes of real interest rates. I conclude by outlining directions for future research.