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A Mind is a Terrible Thing to Change: Confirmation Bias in Financial Markets

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  • Pouget, Sébastien
  • Villeneuve, Stéphane
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    Abstract

    This paper proposes a dynamic model of financial markets where some investors are prone to the confirmation bias. Following insights from the psychological literature, these agents are assumed to amplify signals that are consistent with their prior views. In a model with public information only, this assumption provides a rationale for the volume-based price momentum documented by Lee and Swaminathan (2000). Our results are also consistent with a variety of other empirically documented phenomena such as bubbles, crashes, reversals and excess price volatility and volume. Novel empirical predictions are derived: i) return continuation should be stronger when biased traders' beliefs are more extreme, and ii) return continuation should be stronger after an increase in trading volume. The implications of our model for short-term quantitative investments are twofold: i) optimal trading strategies involve riding bubbles, and that ii) contrarian trading can be optimal in some market circumstances.

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    File URL: http://idei.fr/doc/wp/2012/wp_idei_720.pdf
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    Bibliographic Info

    Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 720.

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    Date of creation: Mar 2012
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    Handle: RePEc:ide:wpaper:25823

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    Related research

    Keywords: financial markets; psychological biases; confirmation bias; momentum; reversal; bubbles; trading strategies;

    This paper has been announced in the following NEP Reports:

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    1. Jeffrey Wurgler & Ekaterina Zhuravskaya, 2000. "Does Arbitrage Flatten Demand Curves for Stocks?," Yale School of Management Working Papers ysm152, Yale School of Management, revised 01 Nov 2001.
    2. Forsythe, Robert & Forrest Nelson & George R. Neumann & Jack Wright, 1992. "Anatomy of an Experimental Political Stock Market," American Economic Review, American Economic Association, vol. 82(5), pages 1142-61, December.
    3. Peter Temin & Hans-Joachim Voth, 2004. "Riding the South See Bubble," Working Papers 213, Barcelona Graduate School of Economics.
    4. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
    5. Mankiw, N Gregory & Romer, David & Shapiro, Matthew D, 1985. " An Unbiased Reexamination of Stock Market Volatility," Journal of Finance, American Finance Association, vol. 40(3), pages 677-87, July.
    6. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    7. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    8. Abreu, Dilip & Brunnermeier, Markus K., 2002. "Synchronization risk and delayed arbitrage," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 341-360.
    9. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
    10. repec:bla:restud:v:74:y:2007:i:4:p:1149-1174 is not listed on IDEAS
    11. Elyès Jouini & Clotilde Napp, 2003. "Consensus consumer and intertemporal asset pricing with heterogeneous beliefs," Finance 0312001, EconWPA.
    12. Markus K. Brunnermeier & Stefan Nagel, 2004. "Hedge Funds and the Technology Bubble," Journal of Finance, American Finance Association, vol. 59(5), pages 2013-2040, October.
    13. Nicholas Barberis & Andrei Shleifer & Robert W. Vishny, 1997. "A Model of Investor Sentiment," NBER Working Papers 5926, National Bureau of Economic Research, Inc.
    14. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
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    1. Weekly Roundup 186: A Curated Linkfest For The Smartest People On The Web!
      by Miguel in Simoleon Sense on 2012-09-16 04:29:18

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