Dual Decision Processes and Noise Trading

Abstract

Evidence from financial markets suggests that asset prices can be consistently far from their funda-mental value. Prices seem to underreact to news in the short-run and overreact in the long-run. In this paper, we use Dual Process Theory to describe traders behavior. In particular, a part of traders holds wrong beliefs anytime the market environment does not change sufficiently. The proportion of traders with wrong beliefs will depend on how similar past market environments are with the present one. We show that such model not only can be seen as a way of endogenizing noise trading, but also provides a justification for noise traders’ beliefs and it shows that underreaction and overreaction naturally arise in such framework. Finally, we discuss how the model might help understanding the emergence of the equity-premium puzzle and its variation through time.