San Francisco Federal Reserve President John WIlliams in a speech today:
Many researchers are probing why people have the procyclical pattern of optimism seen in these surveys. One key element in the theories coming out of this research is that people do not possess the full set of information assumed in the standard asset price model with rational expectations. Instead, they must make do with the limited information at hand when judging likely future discounted dividend payments and the future price of the asset. Indeed, a growing body of evidence in behavioral economics and finance shows that people’s expectations of future asset returns depend on their past experiences.This process of forecasting with limited information has been shown to cause forecast errors that can drive a wedge between asset prices and the values implied by economic fundamentals.
John Maynard Keynes, 1936:
In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention—though it does not, of course, work out quite so simply—lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalise our behaviour by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation. In point of fact, all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield.