Overconfidence and Market Efficiency with Heterogeneous Agents
University of North Carolina at Chapel Hill - Finance Area
Swedish House of Finance
Universitat Pompeu Fabra - Faculty of Economic and Business Sciences
September 1, 2005
Economic Theory, Vol. 30, No. 2, 2007
We study financial markets in which both rational and overconfident agents coexist and make endogenous information acquisition decisions. We demonstrate the following irrelevance result: when a positive fraction of rational agents (endogenously) decides to become informed in equilibrium, prices are set as if all investors were rational, and as a consequence the overconfidence bias does not affect informational efficiency, price volatility, rational traders' expected profits or their welfare. Intuitively, as overconfidence goes up, so does price informativeness, which makes rational agents cut their information acquisition activities, effectively undoing the standard effect of more aggressive trading by the overconfident. The main intuition of the paper, if not the irrelevance result, is shown to be robust to different model specifications.
Number of Pages in PDF File: 28
Keywords: partially revealing equilibria, overconfidence, rational expectations, information
JEL Classification: D80, G10Accepted Paper Series
Date posted: June 23, 2004 ; Last revised: September 18, 2012
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