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Overconfidence and Market Efficiency with Heterogeneous Agents

  • Diego Garcia
  • Francesco Sangiorgi
  • Branko Urosevic

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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Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 11.

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Length: 30 pages
Date of creation: 2005
Date of revision:
Publication status: Forthcoming in Economic Theory
Handle: RePEc:cca:wpaper:11
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  18. Admati, Anat R. & Pfleiderer, Paul, 1986. "A monopolistic market for information," Journal of Economic Theory, Elsevier, vol. 39(2), pages 400-438, August.
  19. KENT D. DANIEL & David Hirshleifer & AVANIDHAR SUBRAHMANYAM, 2004. "A Theory of Overconfidence, Self-Attribution, and Security Market Under- and Over-reactions," Finance 0412006, EconWPA.
  20. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272.
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