Over- and Underreaction to Information: Belief Updating with Cognitive Constraints
Abstract
Accepted at the Quarterly Journal of Economics
This paper examines how cognitive constraints shape whether people overreact or underreact to information. In our model, limited attention distorts how people mentally represent the information environment—generating a misspecified mental model—while limited processing capacity introduces cognitive imprecision when they apply Bayes’ rule to their representation. Our framework predicts overreaction in complex environments, to noisy or surprising signals, and under priors concentrated on moderate states, and underreaction in simple environments, to precise or confirmatory signals, and under priors concentrated on extreme states. A preregistered experiment supports these predictions and provides direct evidence for the proposed mechanisms. Crucially, the observed pattern of bias arises from the interaction of the two constraints; neither alone explains the data. These results reconcile disparate prior findings on when overreaction versus underreaction arises.
