Overconfidence and Market Efficiency with Heterogeneous Agents

Abstract

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

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Correspondence to Diego García.

Additional information

We would like to thank Alberto Bisin, Xavier Freixas, Ken French, Moshe Kim, Jose Marín, and Terrance Odean for comments on an early draft, as well as an anonymous referee and seminar participants at HEC Geneva, the 2004 EFA meetings, the 2004 European Econometric Society meetings and the 2005 SAET conference. Diego García and Branko Urošević gratefully acknowledge financial support by SECCF (Belgrade).

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García, D., Sangiorgi, F. & Urošević, B. Overconfidence and Market Efficiency with Heterogeneous Agents. Economic Theory 30, 313–336 (2007). https://doi.org/10.1007/s00199-005-0048-4

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Keywords

  • Partially revealing equilibria
  • Overconfidence
  • Rational expectations
  • Information acquisition
  • Price informativeness

JEL Classification Numbers

  • D80
  • G10