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Learning To Be Overconfident

39 Pages Posted: 16 Oct 1997  

Simon Gervais

Duke University - Fuqua School of Business; Duke Innovation & Entrepreneurship Initiative

Terrance Odean

University of California, Berkeley - Haas School of Business

Date Written: June 30, 1997

Abstract

We develop a multi-period market model describing both the process by which traders learn about their ability and how a bias in this learning can create overconfident traders. A trader in our model initially does not know his own ability, that is, the probability that he will receive a valid signal in each period. He infers this ability from his successes and failures. In assessing his ability the trader takes too much credit for his successes, i.e. he weighs his successes more heavily than would a true Bayesian agent. This leads him to become overconfident. A trader's expected level of overconfidence increases in the early stages of his career. Then, with more experience, he comes to better recognize his own ability. An overconfident trader trades too aggressively, thereby increasing trading volume and market volatility while lowering his own expected profits. Though a greater number of past successes indicates greater probable ability, a more successful trader may actually have lower expected profits in the next period than a less successful trader due to his greater overconfidence. Since overconfidence is generated by success, overconfident traders are not the poorest traders. Their survival in the market is not threatened. Overconfidence does not make traders wealthier, but the process of becoming wealthy can make traders overconfident.

JEL Classification: G12, G14

Suggested Citation

Gervais, Simon and Odean, Terrance, Learning To Be Overconfident (June 30, 1997). Available at SSRN: https://ssrn.com/abstract=36313 or http://dx.doi.org/10.2139/ssrn.36313

Simon Gervais (Contact Author)

Duke University - Fuqua School of Business ( email )

100 Fuqua Drive
Box 90120
Durham, NC 27708-0120
United States
919-660-7683 (Phone)
919-883-5078 (Fax)

HOME PAGE: http://www.fuqua.duke.edu/faculty_research/faculty_directory/gervais/

Duke Innovation & Entrepreneurship Initiative ( email )

215 Morris St., Suite 300
Durham, NC 27701
United States

Terrance Odean

University of California, Berkeley - Haas School of Business ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
510-642-6767 (Phone)
510-666-2561 (Fax)

HOME PAGE: http://www.haas.berkeley.edu/faculty/odean.html

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