Distinguishing Overconfidence from Rational Best-Response in Markets

36 Pages Posted: 17 Mar 2006

See all articles by Shimon Kogan

Shimon Kogan

Reichman University - Arison School of Business; University of Pennsylvania - The Wharton School

Date Written: February 1, 2006

Abstract

This paper studies the causal effect of individuals' overconfidence and bounded rationality on asset markets. To do that, we combine a new market mechanism with an experimental design, where (1) players' interaction is centered on the inferences they make about each others' information, (2) overconfidence in private information is controlled by the experimenter (i.e., used as a treatment), and (3) natural analogs to prices, returns and volume exist.

We find that in sessions where subjects are induced to be overconfident, volume and price error analogs are higher than predicted by the fully-rational model. However, qualitatively similar results are obtained in sessions where there is no aggregate overconfidence. To explain this, we suggest an alternative possibility: participants strategically respond to the errors contained in others' actions by rationally discounting the informativeness of these actions. Estimating a structural model of individuals' decisions that allows for both overconfidence and errors, we are able to separate these two channels. We find that a substantial fraction of excess volume and price error analogs is attributable to strategic response to errors, while the remaining is attributable to overconfidence. Further, we show that price analog exhibit serial autocorrelation only in the overconfidence-induced sessions.

Keywords: Behavioral finance, overconfidence, asymmetric information, experimental economics, structural estimation, information aggregation

JEL Classification: G14, C92, D82, D40

Suggested Citation

Kogan, Shimon, Distinguishing Overconfidence from Rational Best-Response in Markets (February 1, 2006). Available at SSRN: https://ssrn.com/abstract=891382 or http://dx.doi.org/10.2139/ssrn.891382

Shimon Kogan (Contact Author)

Reichman University - Arison School of Business ( email )

P.O. Box 167
Herzliya, 46150
Israel

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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