Overconfidence and Speculative Bubbles

46 Pages Posted: 31 Jul 2003

See all articles by José Scheinkman

José Scheinkman

Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Wei Xiong

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: February 2, 2003

Abstract

Motivated by the behavior of internet stock prices in 1998-2000, we present a continuous time equilibrium model of bubbles where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other over-confident agents who have more optimistic beliefs. This re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. The model generates prices that are above fundamentals, excessive trading, excess volatility, and predictable returns. However, our analysis shows that while Tobin's tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We give an example where the price of a subsidiary is larger than its parent firm. Finally, we show how overconfidence can justify the use of corporate strategies that would not be rewarding in a "rational" environment.

Note: Previously titled "Overconfidence, Short-Sale Constraints, and Bubbles"

JEL Classification: G12, G14, G30

Suggested Citation

Scheinkman, José and Xiong, Wei, Overconfidence and Speculative Bubbles (February 2, 2003). 13th Annual Utah Winter Finance Conference; AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=298865 or http://dx.doi.org/10.2139/ssrn.298865

José Scheinkman

Columbia University ( email )

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Princeton University - Department of Economics ( email )

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HOME PAGE: http://www.princeton.edu/~joses

National Bureau of Economic Research (NBER)

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Wei Xiong (Contact Author)

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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