Information Characteristics and Errors in Expectations: Experimental Evidence

Behavioural finance theories draw on evidence from psychology that suggest that some people respond to information in a biased manner, and construct theories of inefficient markets. However, these biases are not always robust when tested in economic conditions, which casts doubt on their relevance to market efficiency. We design an economic experiment to test a psychological hypothesis of errors in expectations widely cited in finance, which states that, in violations of Bayes Rule, some people respond more forcefully to the strength of an information signal. The strength of a signal is how saliently it supports a specific hypothesis, as opposed to its weight, which is its predictive validity. We find that the strength-weight bias affects expectations, but that its magnitude is three times lower than originally reported in the psychology literature. This suggests that its impact on financial markets is likely to be smaller than originally thought.