Under-reaction: Irrational behavior or robust response to model misspecification?

Abstract I find that under-reaction is a robust response to model misspecification, rewarded by financial markets, rather than an “irrational” attitude that leads to extinction. When a Bayesian agent trades with an under-reacting agent who has access to the same information, there are no paths on which the under-reacting agent loses all his wealth to the Bayesian. Conversely, the Bayesian agent loses all his wealth to the under-reacting agent in misspecified learning settings, provided that a combination of parameters is more accurate than any single parameter in the support, and the under-reaction is sufficiently strong.