Can Agents Add and Subtract when Forming Beliefs? Evidence from the Lab and Field
64 Pages Posted: 3 Aug 2020 Last revised: 29 Nov 2021
Date Written: July 6, 2020
We study an intrinsic property of Bayesian information processing which does not rely on individuals having rational absolute beliefs: two equally-diagnostic signals of opposite direction should cancel out. Using evidence from both the lab and field, we show that individuals not always follow this counting-based principle. Systematic violations occur whenever a sequence of identical evidence is interrupted by a signal of opposite direction, which produces strong and robust overreactions. Conversely, individuals correctly follow this counting-based principle whenever signals alternate while they underreact to sequences of same-directed evidence. Next, we empirically analyze announcement and post-announcement stock return reactions in financial markets. Consistent with our experimental evidence, we find that initial stock reactions are significantly stronger and subsequent price drifts weaker for opposite-directed earnings surprises than for same-directed earnings surprises. Our results provide novel insights to the paradoxical co-existence of over- and underreaction to new information at the individual and market level.
Keywords: Belief Formation, Bayes' Theorem, Information Processing, Overreaction
JEL Classification: D81, D83, D84, G41
Suggested Citation: Suggested Citation