DP19576 Over- and Underreaction to Information: the Role of Complexity in Belief-Updating
This paper explores how cognitive constraints---namely, attention and processing capacity---interact with properties of the learning environment to determine how people react to information. In our model, people form a simplified mental representation of the environment via salience-channeled attention, then process information with cognitive imprecision. The model predicts overreaction to information when environments are complex, signals are noisy, information is surprising, or priors are concentrated on less salient states; it predicts underreaction when environments are simple, signals are precise, information is expected, or priors are concentrated on salient states. Results from a series of pre-registered experiments provide support for these predictions and direct evidence for the proposed cognitive mechanisms. We show that the two psychological mechanisms act as cognitive complements: their interaction is critical for explaining belief data and together they yield a highly complete model in terms of capturing explainable variation in belief-updating. Our theoretical and empirical results connect disparate findings in prior work: underreaction is typically found in laboratory studies, which feature simple learning settings, while overreaction is more prevalent in financial markets which feature greater complexity.
