Does Society Benefit from Investor Overconfidence in the Ability of Financial Market Experts?
Journal of Economic Behavior and Organization, Vol. 58, pp. 95-116, 2005
22 Pages Posted: 15 Oct 2010
Date Written: 2005
Abstract
This paper develops a securities market model in which participants’ beliefs diverge and prices are monotonic in beliefs. Relative to rational expectations (i.e., correct and unanimous beliefs), overconfidence among uninformed traders about the precision of experts’ information leads to Pareto-superior equilibria. Efficiency-enhancing departures from rational expectations occur over a dense subset of parameter space, but only for one configuration of beliefs: uninformed traders must be more confident than informed experts. Overconfidence in the form of excessive trust in the predictive ability of experts sets off a virtuous cycle of increased trading that improves liquidity and reduces transaction costs for everyone.
Keywords: Overconfidence, Heterogeneous beliefs, Disagreement, Financial markets, Expert, Trust
JEL Classification: D03, D84, D82, G12, D62
Suggested Citation: Suggested Citation
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