Confirming Signals are Hard to Resist: Blessing and Curse of Information Under Confirmation Bias

Ample empirical evidence documents that individuals pay more attention to confirming than to contradicting evidence. In the context of the so-called confirmation bias, we first study the effects of additional information on perception correctness - contrasting the competing effects of total signal precision and the possibility to search for the most suitable signal. We provide the testable hypothesis that managers inform about bad news in a more diffuse signal compared to good news. This in turn provides an explanation of the dispersion anomaly: disperse signals are followed by underperformance. Second, we study the effects of confirmation bias in an overlapping generations model with a continuous signal distribution. Several results of more simplified models do not hold true any longer - e.g. confirmation bias leads to initial underreaction instead of overreaction. In a framework with endogenous market entry and exit, this initial underreaction triggers subsequent overreaction. This momentum effect is accompanied by time varying market participation, announcement day and market depth effects.