The Effects of Biases in Probability Judgments on Market Prices

Abstract:     
Experimental Markets were used to examine whether individual probability judgment biases affect market prices. This issue is important to accountants because users of accounting information (especially investors) face competitive market environments. The expectation was that it would be more difficult for prices to be unbiased in markets where biased traders had the highest expected payoffs than in markets where unbiased traders had the highest expected payoffs. This expectation arose from the observation that competitive forces would produce biased prices when biased traders had the highest expected payoffs unless either (1) biased traders learned to be unbiased as a result of market experience, or (2) biased traders were inactive, thus allowing unbiased traders to set prices. Consistent with expectations, prices were biased in a market where biased traders had the highest expected payoffs, with prices moving toward unbiased prices but remaining more biased than biased overall. The results of this study suggest that individual judgment biases can have a substantial effect on market prices, and, consequently, demonstrations of individual investor judgment biases should be of concern to accountants.

Keywords: investor, bias, expectation, optimism, pessimism

JEL Classification: C91, C92, D40, D41, D44, D82, E31, G10, G12, M40

Accepted Paper Series