Economic decisions are often driven by beliefs, not just cold, hard facts. People don’t simply analyze the data in front of them when forming opinions and expectations. Instead, they tap into their memory banks, drawing on relevant past knowledge and experiences. This interplay between memory and economic belief formation is the central focus of a five-year research project funded by an ERC starting grant and led by IZA Research Director Florian Zimmermann.
In a new paper now published in the Journal of Financial Economics, co-authored with Benjamin Enke and Frederik Schwerter, Zimmermann presents the first findings from this project. The research provides experimental evidence that associative memory can lead to a systematic overreaction of beliefs crucial for navigating markets. These findings challenge traditional economic models that rely on the assumption of purely rational belief formation and decision-making.
Memory and investment decisions
Our memories work by association, making it easier to recall past experiences that are similar to the contexts of current situations. In the stock market, these contexts can be positive news stories or images of rising charts. When forming investment beliefs, we rely on readily available memories, which can lead to skewed assessments. For example, a string of good news articles might trigger memories of past market booms, even if the current situation isn’t exactly the same.
Experiments reveal overreaction
The researchers conducted two experiments. The first analyzed how associative memory impacts how we evaluate companies. Participants received information about hypothetical companies over two time periods. Their opinions about the companies were more heavily influenced by news that resembled information they received earlier, suggesting associative recall plays a role in overreactions to real-world financial news.
The second experiment, a controlled betting market, showed that this distorted perception translates to market behavior. Prices reacted much more strongly to positive or negative news when these news remind people of similar news from the past.
Beyond rationality
These findings provide evidence for the significant role associative memory plays in shaping economic beliefs and decisions. While real-world decision-making is complex, this research sheds light on the psychological foundations that shape how we react to information and how this reaction can influence market outcomes.