Longshots, Overconfidence and Efficiency on the Iowa Electronic Market
49 Pages Posted: 19 Jul 2010 Last revised: 14 Sep 2017
Date Written: September 12, 2017
The prediction market literature proposes that markets efficiently incorporate all available information. In contrast, behavioral finance assumes individual decision-making biases affect financial markets. We examine both using Iowa Electronic Market (IEM) data. We ask whether markets appear efficient or if longshot or overconfidence biases affect market prices. The IEM mixes many desirable research features from betting markets (prone to longshot biases) with a closer parallel to naturally occurring financial markets (where researchers look for evidence of overconfidence), and the two biases yield opposing predictions. No longshot bias appears in IEM markets. Nor does overconfidence influence prices at short horizons. However, overconfident traders may bias prices at intermediate horizons. While the markets are efficient at short horizons, non-market data indicate some long-horizon inefficiency. When markets appear inefficient, we calculate Sharpe ratios for static trading strategies and document returns for dynamic trading strategies to show the economic content of the inefficiencies.
Keywords: Finance. Asset pricing, Overconfidence, Behavioral Finance, Prediction Markets, Longshot Bias
JEL Classification: C93, G12, G13
Suggested Citation: Suggested Citation