Disconfirming Information and Overreaction in Expectations

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 a field application in financial markets, we show that this is not always the case. Across all settings, individuals systematically overreact to new information that disconfirms prior signals while they underreact to streaks of confirming information. 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