A Mind is a Terrible Thing to Change: Confirmatory Bias in Financial Markets
69 Pages Posted: 17 Sep 2016
Date Written: September 15, 2016
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: Suggested Citation