Volume, Volatility, Price, and Profit When All Traders Are Above Average

Authors

  • Terrance Odean

    1. University of California, Davis
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    • University of California, Davis. This paper is based on my dissertation at the University of California, Berkeley. I thank Brad Barber, Minder Cheng, Simon Gervais, David Hirshleifer, Bill Keirstead, Hayne Leland, Mark Rubinstein, Paul Ruud, Hersh Shefrin, René Stulz, Richard Thaler, two anonymous referees, and seminar participants at UC Berkeley and at the Russell Sage Foundation Summer Institute in Behavioral Economics for their comments. I especially thank Brett Trueman for his numerous suggestions and comments. Financial support from the Nasdaq Foundation and from the American Association of Individual Investors is gratefully acknowledged.

Abstract

People are overconfident. Overconfidence affects financial markets. How 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 marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. 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, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.

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