A Quantitative Behavioral Model and Its Implications for Market Volatility, Underreaction, and Overreaction

This paper develops a model of weight assignments using a pseudo-Bayesian approach that reflects investors’ behavioral biases. In this parsimonious model of investor sentiment, weights induced by investors’ conservative and representative heuristics are assigned to observations of the earning shocks of stock prices. Such weight assignments enable us to provide a quantitative link between some market anomalies and investors’ behavioral biases. The seriousness of an anomaly can be quantitatively assessed by investigating into its dependency on weights. New results other than the shortrun overreaction and long-run overreaction can be derived and new hypotheses can be formed.