Detecting Regime Shifts: The Causes of Under- and Overreaction

Many decision makers operate in dynamic environments in which markets, competitors, and technology change regularly. The ability to detect and respond to these regime shifts is critical for economic success. We conduct three experiments to test how effective individuals are at detecting such regime shifts. Specifically, we investigate when individuals are most likely to underreact to change and when they are most likely to overreact to it. We develop a system-neglect hypothesis: Individuals react primarily to the signals they observe and secondarily to the environmental system that produced the signal. The experiments, two involving probability estimation and one involving prediction, reveal a behavioral pattern consistent with our system-neglect hypothesis: Underreaction is most common in unstable environments with precise signals, and overreaction is most common in stable environments with noisy signals. We test this pattern formally in a statistical comparison of the Bayesian model with a parametric specification of the system-neglect model.