Under-reaction: Irrational behavior or robust response to model misspecification?

20 Pages Posted: 19 Jul 2020 Last revised: 21 Jul 2020

See all articles by Filippo Massari

Filippo Massari

University of Bologna, Department of Economics

Date Written: June 26, 2020

Abstract

Under-reaction is a robust response to model misspecification rewarded by financial markets, rather than an “irrational” attitude that leads to extinction. I show that under-reacting rules guarantee predictions as accurate as Bayes’ in well-specified learning problems and beat Bayes’ in many misspecified learning environments. Therefore, when a Bayesian agent trades with an under-reacting agent with the same information, there are no paths on which the under-reacting agent loses all his wealth against the Bayesian, while there is a large class of misspecified learning settings in which the Bayesian agent loses all his wealth against the under-reacting agent.\\

Keywords: mis-specified learning, under-reaction, market selection, behavioral finance

JEL Classification: D53, D83, D9,G1, G4

Suggested Citation

Massari, Filippo, Under-reaction: Irrational behavior or robust response to model misspecification? (June 26, 2020). Available at SSRN: https://ssrn.com/abstract=3636136 or http://dx.doi.org/10.2139/ssrn.3636136

Filippo Massari (Contact Author)

University of Bologna, Department of Economics ( email )

Bologna
Italy

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