Representativeness Heuristic Can Cause Asset Price Underreaction to New Information in a Competitive Securities Market

Abstract

In the literature, representativeness heuristic is commonly viewed as a cause of asset price overreaction to new information. This paper proves that representativeness heuristic can cause asset price under-reaction to new information in a competitive securities market. Specifically, there is one risk-free asset and one risky asset. Both rational and heuristic traders trade can against each other or against noise traders whose demand is random. The payoff of the risky asset is unknown but all traders receive an informational signal about the risky asset’s payoff before any trading takes place. Due to the representativeness heuristic, the updated mean of the risky asset’s payoff for heuristic traders is higher (lower) than that for rational traders when the realization of the informational signal is above (below) the expected payoff of the risky asset. The results of the paper suggest that regardless of noise traders being net buyers or sellers, the representativeness heuristic causes the asset price to overreact to new information close to the expected payoff of the risky asset and causes the asset price to underreact to new information far above or below the expected payoff of the risky asset.