Overconfidence and Market Efficiency with Heterogeneous Agents
28 Pages Posted: 23 Jun 2004 Last revised: 13 Sep 2016
Date Written: September 1, 2005
We study financial markets in which both rational and overconfident agents coexist and make endogenous information acquisition decisions. We demonstrate the following irrelevance result: when a positive fraction of rational agents (endogenously) decides to become informed in equilibrium, prices are set as if all investors were rational, and as a consequence the overconfidence bias does not affect informational efficiency, price volatility, rational traders' expected profits or their welfare. Intuitively, as overconfidence goes up, so does price informativeness, which makes rational agents cut their information acquisition activities, effectively undoing the standard effect of more aggressive trading by the overconfident. The main intuition of the paper, if not the irrelevance result, is shown to be robust to different model specifications.
Keywords: partially revealing equilibria, overconfidence, rational expectations, information
JEL Classification: D80, G10
Suggested Citation: Suggested Citation