Investments, tenth edition

  Forecasting Errors   

A series of experiments by Kahneman and Tversky  

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    indicate  that 

people give too much weight to recent experience compared to prior beliefs when mak-

ing forecasts (sometimes dubbed a  memory bias ) and tend to make forecasts that are too 

extreme given the uncertainty inherent in their information. DeBondt and Thaler  

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    argue 

that the P/E effect can be explained by earnings expectations that are too extreme. In this 

view, when forecasts of a firm’s future earnings are high, perhaps due to favorable recent 

performance, they tend to be  too  high relative to the objective prospects of the firm. This 

results in a high initial P/E (due to the excessive optimism built into the stock price) and 

poor subsequent performance when investors recognize their error. Thus, high P/E firms 

tend to be poor investments.