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

  • Pouget, Sébastien
  • Villeneuve, Stéphane

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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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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  1. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
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  12. 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.
  13. 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.
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  15. 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.
  16. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
  17. Abreu, Dilip & Brunnermeier, Markus K., 2002. "Synchronization risk and delayed arbitrage," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 341-360.
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