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

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.

Research highlights▶ Self-fulfilling and self-destroying expectations coexist in financial markets. ▶ We show the two phenomena in one consolidated model with specific expectation rules. ▶ Individuals’ realized payoffs decide rules’ impacts on prices. ▶ One rule's impact on price is crucial for its pattern arising and disappearing. ▶ The life cycle of one expectation rule is roughly exhibited.