Price discovery in the presence of boundedly rational agents

In this paper we propose a sequential model of security trading which, compared to existing models, is extended along the notions of (Simon, H.A., A behavioral model of rational choice. Quart. J. Econ., 1955 Simon, HA. 1955. A behavioral model of rational choice. Quart. J. Econ., 64: 99–118.  Google Scholar], 64, 99–118; Rubinstein, A., Modeling Bounded Rationality, Zeuthen Lecture Book Series, 1998 (MIT Press: Cambridge, MA), and Odean, T., Do investors trade too much? Am. Econ. Rev., 1999, 89(5), 1279–1298) by adding boundedly rational traders. Our results indicate that both momentum and mean-reversion in asset prices can be attributed to the presence of agents who are subject to systematic errors in the process of forecasting the liquidation value of a risky security. The length of the momentum period is inversely related to both the amount of information-based trading in the market and the rate at which asset specific information is learned by boundedly rational agents. Furthermore, the model allows explicitly to establish a link between the component of the bid–ask spread that can be explained by bounded rationality and both momentum and reversal.