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We design an experiment to study how investors form their expectations and make risky investments under different market conditions. Together with the past realizations of a risky asset, our subjects observe a signal a that, in some rounds, helps predict future returns. When subjects perceive a as useless, they irrationally extrapolate from recent return realizations. When they perceive a as useful, instead, they correctly incorporate it and extrapolate much less. We interpret those findings in a forecast model in which subjects have imperfect ability to detect predictability and face uncertainty about the correlation between signal a and future returns. We also find that the level of risky investment and its elasticity to forecasts are larger when a is perceived as useful, suggesting that subjects recognize that predictability in our setting reduces risk. Yet, the elasticity of investments to forecasts remains low -- a puzzle relative to their high risky investment. |
