orderly, and usually proportional to numbers calculated from the Bayes
Theorem—but it is insufficient in amount. A conventional first approxi-
mation to the data would say that it takes anywhere from two to five ob-
servations to do one observation’s worth of work in inducing a subject to
change his opinions” (p. 359).
Conservatism is extremely suggestive of the underreaction evidence de-
scribed above. Individuals subject to conservatism might disregard the full
information content of an earnings (or some other public) announcement,
perhaps because they believe that this number contains a large temporary
component, and still cling at least partially to their prior estimates of earn-
ings. As a consequence, they might adjust their valuation of shares only
partially in response to the announcement. Edwards would describe such
behavior in Bayesian terms as a failure to properly aggregate the informa-
tion in the new earnings number with investors’ own prior information to
form a new posterior earnings estimate. In particular, individuals tend to
underweight useful statistical evidence relative to the less useful evidence
used to form their priors. Alternatively, they might be characterized as
being overconfident about their prior information.
A second important phenomenon documented by psychologists is the
representativeness heuristic (Tversky and Kahneman 1974): “A person
who follows this heuristic evaluates the probability of an uncertain event,
or a sample, by the degree to which it is (1) similar in its essential proper-
ties to the parent population, and, (2) reflects the salient features of the
process by which it is generated” (p. 33). For example, if a detailed de-
scription of an individual’s personality matches up well with the subject’s
experiences with people of a particular profession, the subject tends to sig-
nificantly overestimate the actual probability that the given individual be-
longs to that profession. In overweighting the representative description,
the subject underweights the statistical base-rate evidence of the small frac-
tion of the population belonging to that profession.
An important manifestation of the representativeness heuristic, discussed
in detail by Tversky and Kahneman, is that people think they see patterns in
truly random sequences. This aspect of the representativeness heuristic is
suggestive of the overreaction evidence described above. When a company
has a consistent history of earnings growth over several years, accompanied
as it may be by salient and enthusiastic descriptions of its products and man-
agement, investors might conclude that the past history is representative of an
underlying earnings growth potential. While a consistent pattern of high
growth may be nothing more than a random draw for a few lucky firms, in-
vestors see “order among chaos” and infer from the in-sample growth path
that the firm belongs to a small and distinct population of firms whose earn-
ings just keep growing. As a consequence, investors using the representative-
ness heuristic might disregard the reality that a history of high earnings
growth is unlikely to repeat itself; they will overvalue the company, and be
A MODEL OF INVESTOR SENTIMENT 431