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.
Volume, Volatility, Price, and Profit
When All Traders Are Above Average
Terrance Odean
Abstract
