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A Mind is a Terrible Thing to Change: Confirmatory Bias in Financial Markets

69 Pages Posted: 17 Sep 2016  

Sebastien Pouget

Toulouse School of Economics

Julien Sauvagnat

Bocconi University; Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research

Stephane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE)

Date Written: September 15, 2016

Abstract

This paper studies the impact of the confirmatory bias on financial markets. Building on Rabin and Schrag (1999), we propose a model in which some traders may ignore new evidence when it is inconsistent with their favorite hypothesis regarding the state of the world. The confirmatory bias provides a unified rationale for several existing stylized facts including excess volatility, excess volume and momentum. It also delivers novel predictions: at the individual level, traders' belief updating depends on the sign of past signals and previous beliefs, and, at the stock level, differences of opinion should be larger when past subsequent signals have different signs. Using data on US firms' earnings announcements and analysts' earnings forecasts from 1982 to 2014, we find strong empirical support for these predictions, suggesting that the confirmatory bias is at work in financial markets.

Keywords: financial markets, psychological biases, confirmatory bias, momentum, bubbles, trading strategies, differences of opinion, analysts' forecasts.

JEL Classification: G02

Suggested Citation

Pouget, Sebastien and Sauvagnat, Julien and Villeneuve, Stephane, A Mind is a Terrible Thing to Change: Confirmatory Bias in Financial Markets (September 15, 2016). Available at SSRN: https://ssrn.com/abstract=2839249 or http://dx.doi.org/10.2139/ssrn.2839249

Sebastien Pouget

Toulouse School of Economics ( email )

21 allée de Brienne
31015 Toulouse Cedex 6
France

Julien Sauvagnat (Contact Author)

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

Bocconi University - IGIER - Innocenzo Gasparini Institute for Economic Research ( email )

Via Roentgen 1
Milan, 20136
Italy

Stéphane Villeneuve

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

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