Representativeness Heuristic and Asset Price Overreaction or Underreaction to New Information in a Competitive Securities Market

Abstract

This chapter examines how representativeness heuristic causes the asset price to overreact or underreact to good news or bad news. Specifically, this chapter constructs a static model of a competitive securities market. In the market, there are two assets: risk-free asset and risky asset. The payoff of the risk-free asset is one and the payoff of the risky asset is normally distributed. In addition, there are three types of traders: rational traders, heuristic traders and noise traders. Noise traders trade for their liquidity reasons. Hence, noise traders’ demand for the asset is assumed to be random. Heuristic traders exhibit representativeness heuristic. Before any trade occurs, rational and heuristic traders receive an informational signal about the asset payoff. Due to the representativeness heuristic, heuristic traders place too much weight on the new information and not enough weight on their prior knowledge. In other words, if the signal is greater (smaller) than the expected payoff of the asset, then a heuristic trader has a larger (smaller) conditional mean of the asset than a rational trader does; in addition, for any given informational signal, a heuristic trader has a smaller conditional variance of the asset payoff than a rational trader does. Both rational and heuristic traders have an exponential utility function. In the competitive securities market, traders take the asset price as given.