Over- and Underreaction to Information: Belief Updating with Cognitive Constraints

This paper explores how cognitive constraints interact with the information environment to determine whether people overreact or underreact to information. In our model of belief updating, limited attention leads people to form a distorted mental model or representation of the information environment, and limited processing capacity generates cognitive imprecision when using this representation to update beliefs. The model predicts overreaction when facing complex environments, noisy or surprising signals, or priors concentrated on moderate states; it predicts underreaction when facing simple environments, precise or confirmatory signals, or priors concentrated on extreme states. A series of pre-registered experiments provide support for these predictions and direct evidence for the proposed cognitive mechanisms. Crucially, the interaction between the cognitive constraints generates the observed pattern of bias: neither constraint on its own can explain the data. These results connect prior disparate findings on whether underreaction versus overreaction arises.