Dr. Yaron Lahav
Thinking Near and Far: Modeling Underreaction, Overreaction and the Formation of Traders’ Beliefs in Asset Markets using Experimental Data
We present a dynamic model that expresses how traders use historical price patterns and recent trends and the weights they assign to each information set when predicting future market behavior. We show that although traders initially have more faith in the validity of information about historical events, in light of recent price changes, they gradually shift their reliance to more current market trends as they realize that the prices they are witnessing do not follow the historical patterns. As soon as the price trend changes again, however, traders’ confidence in the information contained in historical events is restored, and they consequently rely less on the more current price changes. The model can explain the phenomena of underreaction and overreaction by showing how the reinforcement of the traders’ prior beliefs affects their confidence in the market information to which they are exposed and the resulting weights they assign to that information.