Overinference from Weak Signals and Underinference from Strong Signals
67 Pages Posted: 30 Dec 2022 Last revised: 13 May 2023
Date Written: March 21, 2023
We study how overreaction and underreaction to signals depend on their informativeness. While a large literature has studied belief updating in response to highly informative signals, people in important real-world settings are often faced with a steady stream of weak signals. We use a tightly controlled experiment and new empirical evidence from betting and financial markets to demonstrate that updating behavior differs meaningfully by signal strength: across domains, our consistent and robust finding is overreaction to weak signals and underreaction to strong signals. Both sets of results align well with a simple theory of cognitive imprecision about signal informativeness. Our framework and findings can help harmonize apparently contradictory results from the experimental and empirical literatures.
JEL Classification: C91, D83, D91, G14, G41
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