Over-/Under-reaction and Judgment Noise in Expectation Formation
The correlation coefficients between forecast errors and forecast revisions have been found to be positive at the consensus level, but negative at the individual level. Past literature has interpreted such discrepancy as evidence for underreaction to news at the aggregate level and overreaction at the individual level. In this paper, I challenge this view by arguing that noise in predictive judgment can account for the puzzling discrepancy. Using a stylized model, I examine how introducing judgment noise at the individual level changes the interpretation of the regression coefficients. First, a negative coefficient at the individual level no longer means overreaction. Second, the coefficient at the consensus level underestimates the degree of underreaction. Using forecast survey data, I provide evidence that judgment noise is large enough to reconcile the difference between the two coefficients. The structural parameter measuring over-/underreaction mostly points to underreaction.
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