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

See all articles by Pascal Kieren

Pascal Kieren

University of Mannheim

Jan Müller-Dethard

University of Mannheim

Martin Weber

University of Mannheim - Department of Banking and Finance

Date Written: July 6, 2020

Abstract

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

Kieren, Pascal and Müller-Dethard, Jan and Weber, Martin, Can Agents Add and Subtract when Forming Beliefs? Evidence from the Lab and Field (July 6, 2020). Proceedings of Paris December 2021 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3644226 or http://dx.doi.org/10.2139/ssrn.3644226

Pascal Kieren

University of Mannheim ( email )

Deparment of Finance, L9, 1-2
Mannheim, 68131
Germany

Jan Müller-Dethard (Contact Author)

University of Mannheim ( email )

Department of Finance, L9, 1-2
Mannheim, 68131
Germany

Martin Weber

University of Mannheim - Department of Banking and Finance ( email )

D-68131 Mannheim
Germany
+49 621 181 1532 (Phone)
+49 621 181 1534 (Fax)

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