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Volume, Volatility, Price and Profit When All Traders Are Above Average

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  • Terrance Odean

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

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    Abstract

    Psychological studies establish that people are usually overconfident and that they systematically overweight some types of information while underweighting others. How overconfidence affects a financial market depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse market-makers are overconfident. It also analyzes the effects of overconfidence when information is costly. In all scenarios, overconfidence increases expected trading volume and market depth while lowering the expected utility of those who are overconfident. However, its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, or highly relevant information, while they overreact to salient, anecdotal, or less relevant information.

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    Bibliographic Info

    Paper provided by EconWPA in its series Finance with number 9803001.

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    Length: 49 pages
    Date of creation: 12 Mar 1998
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:9803001

    Note: 49 pages, including table and figures. Revised copy of text, Submitted as postscript.
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    Web page: http://128.118.178.162

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