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A consolidated model of self-fulfilling expectations and self-destroying expectations in financial markets

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  • Gao, Yan
  • Li, Honggang

Abstract

Self-fulfilling expectations, where people's expectations may enable some 'pattern' to arise, and self-destroying expectations, where people's expectations could also induce the arisen 'pattern' to disappear, are two attracting phenomena in financial markets. We hold that these two seemingly conflicting phenomena originally arise from the intertemporal payoff structure of investors and build a consolidated model to systemically explore their underlying mechanisms. Based on individuals' investments, with trend-following and trend-reversing expectation rules, our model exhibits the process in which one expectation rule goes from showing superior performance to being unprofitable, as it is gradually exploited, realized, and taken advantage of. Adding the fundamentalist rule, we find that the fluctuation of fundamentalists' impacts on prices, driven by individuals' real payoffs, is the crucial factor that enables their wished 'pattern' that prices fluctuate around the supposed fundamental value to arise as well as induces this emerging 'pattern' to disappear.

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  • Gao, Yan & Li, Honggang, 2011. "A consolidated model of self-fulfilling expectations and self-destroying expectations in financial markets," Journal of Economic Behavior & Organization, Elsevier, vol. 77(3), pages 368-381, March.
    • Handle: RePEc:eee:jeborg:v:77:y:2011:i:3:p:368-381
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    2. Gerunov, Anton, 2014. "Критичен Преглед На Основните Подходи За Моделиране На Икономическите Очаквания [A Critical Review of Major Approaches for Modeling Economic Expectations]," MPRA Paper 68797, University Library of Munich, Germany.
    3. Figurska Marta & Wisniewski Radoslaw, 2016. "Fundamental Analysis – Possiblity of Application on the Real Estate Market," Real Estate Management and Valuation, Sciendo, vol. 24(4), pages 35-46, December.

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