Dual decision processes and noise trading

Evidence from nancial markets suggests that asset prices can be consistently far from their funda-\nmental value. Prices seem to underreact to news in the short-run and overreact in the long-run. In\nthis paper, we use Dual Process Theory to describe traders behavior. In particular, a part of traders\nholds wrong beliefs anytime the market environment does not change suciently. The proportion of\ntraders with wrong beliefs will depend on how similar past market environments are with the present\none. We show that such model not only can be seen as a way of endogenizing noise trading, but\nalso provides a justication for noise traders' beliefs and it shows that underreaction and overreaction\nnaturally arise in such framework. Finally, we discuss how the model might help understanding the\nemergence of the equity-premium puzzle and its variation through time.