On the nature of expectations

We review economic and psychological models of expectation formation. According to the rational model, expectations are optimal; according to the adaptive model, they minimize previous error; according to the extrapolative model, they continue a trend. In an experiment, we asked subjects to make forecasts from previous data in the same series or from previous data in a different but related series. We also asked them to estimate the probability that their forecasts would be correct. The rational model failed because within-series forecasts were too poor, cross-series forecasts were biased, and probability estimates showed overconfidence. Regression analyses and a lack of performance improvement showed that the adaptive model was inappropriate. Instead, within-series forecasts were made by extrapolation and cross-series forecasts appeared to be based on a faulty conditional rule.