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Overconfidence and Market Efficiency with Heterogeneous Agents

  • Diego García

    ()

  • Francesco Sangiorgi

    ()

  • Branko Urošević

    ()

We study financial markets in which both rational and overconfident agents coexist and make endogenous information acquisition decisions. We demonstrate the following irrele- vance 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 conse- quence the overconfidence bias does not affect informational efficiency, price volatility, ra- tional 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 overcon- fident. The main intuition of the paper, if not the irrelevance result, is shown to be robust to different model specifications.

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File URL: http://hdl.handle.net/10.1007/s00199-005-0048-4
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Article provided by Springer in its journal Economic Theory.

Volume (Year): 30 (2007)
Issue (Month): 2 (February)
Pages: 313-336

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Handle: RePEc:spr:joecth:v:30:y:2007:i:2:p:313-336
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