Can Agents Add and Subtract When Forming Beliefs? Evidence from the Lab and Field

Abstract

We study an intrinsic property of Bayesian information processing that does not rely on individuals having rational absolute beliefs: two equally-diagnostic signals of opposite direction should cancel out. Using five preregistered experiments and financial market data on analyst forecasts and earnings announcements, we show that this is not always the case. In both settings, investors systematically overreact to new information that disconfirms prior signals. As mechanism, we identify that individuals update their expectations as if they must selectively allocate their cognitive resources. Overall, our study provides novel insights to the paradoxical co-existence of both over- and underreaction to new information.

Keywords: Belief Formation, Bayes' Theorem, Information Processing, Overreaction

JEL Classification: D81, D83, D84, G41