Underreactions and Overreactions: The Influence of Information Reliability and Portfolio Formation Rules

Abstract

This paper shows that whether laboratory markets over- or under-react to information is influenced by two factors: the reliability of investors' information and the portfolio formation rule used to identify price anomalies. Consistent with research in psychology, prices tend to over-react to unreliable information and under-react to highly reliable information, because investors' confidence in their information is moderated toward a central level. Forming portfolios on the basis of price changes tends to yield larger apparent overreactions than forming portfolios on the basis of information that is independent of market price, because market prices include mean-reverting random errors (in addition to systematic price errors due to moderated confidence). These results can help empirical researchers develop specific alternative hypotheses to market efficiency, by helping them predict ex ante whether a given research study is likely to reveal over- or underreactions.

JEL Classification: G12, C92