Heterogeneity in Investor Confidence and Asset Market Under-and Overreaction

Abstract

This paper develops a behavioral finance model that may explain underreaction and overreaction in asset markets from the perspective of heterogeneous investors with different confidence levels. The model explains the occurrence of underreaction by the sequential entry of investors with different confidence levels in interpreting earnings shocks. When the average investor confidence level is high enough, owing to the stochastic nature of the fundamental value and the change in order flow and trading volume, it is likely for asset price to overshoot what the fundamental value warrants, leading to overreaction and negative autocorrelation of asset returns. It is shown that in repeated trading episodes with repeated earnings shocks, the average investor confidence level would be higher as a result of the biased self-attribution and confirmatory bias, causing overreaction more likely to occur. Also, the higher average confidence level of investors gauged by the later timing of winding up their asset holding positions also makes overreaction more likely to occur.