Extrapolation and Rational Inattention: Evidence from Chinese Mutual Funds

Investors and forecasters often extrapolate from past returns, but whether this reflects behavioral bias or efficient information processing remains unclear. We address this question by inferring Chinese mutual fund managers' market expectations from textual analysis of their commentaries and linking them to portfolio choices and performance. Extrapolation is state-dependent: it is stronger when growth is above trend and idiosyncratic risk is relatively more important. It is associated with weaker market timing and stronger stock picking, leaving overall performance unchanged. Our findings support a rational-inattention model of expectation formation, in which managers shift scarce attention between aggregate and stock-specific information as the relative importance of different risks change.