How Do U.S. and Japanese Investors Process Information and How Do They Form Their Expectations of the Future? Evidence From Quantitative Survey Based Data

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Abstract
This study utilizes contemporaneously sampled survey data on the expectations of U.S. and Japanese investors regarding future levels of the DJIA and the NIKKEI stock indices. The survey covers the period 1989-1999. The expectation data is used to compute direct tests of investor rationality and efficiency, and to provide evidence on the type of expectations mechanism which best characterises the evolution of expectations. Using SUR and Kalman Filter estimation techniques, the results suggest that, on average, investors are biased and inefficient processors of information, with expectations being formed adaptively as a weighted function of past forecast errors but one where the weights vary over time. For U.S. institutional investors in the DJIA and the NIKKEI, the time path of the expectation correction appears to be time-varying but stable. For Japanese institutional investors in these indices, the evidence also suggests non-constant expectation corrections but these are unstable with no fixed mean value. The general implications of this study can be simply stated. First, given the bias and inefficient nature of expectations, analysts should take care in using expectations data as an investment tool. Over the period the trend has been for the DJIA expectations to be biased in a downward direction while the NIKKEI expectations tend to be biased in an upward direction. Second, as investors tend to form their expectations adaptively, the revealed forecast error may provide additional information to the analyst on probable movements in the market. The expectation 'correction' however, will be related to the impact of news arrival at the marketplace. Our results also suggest that auxiliary assumptions, such as rationality and the type of expectation formation should be key issues in the formulation of the empirical framework imposed by academic and professional financial researchers.