Financial Speculators' Underperformance: Learning, Self-Selection, and Endogenous Liquidity




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    • Mahani is with the Finance Department, Georgia State University. Bernhardt is with the Department of Economics, University of Illinois at Urbana-Champaign. A significant part of this research was conducted while the first author was a doctoral student at the University of Illinois at Urbana-Champaign. We thank an anonymous referee, George Deltas, Eric Hughson, Charlie Kahn, Neil Pearson, Allen Poteshman, Rob Stambaugh (editor), Josh White, and audiences at the 2005 American Finance Association meeting, University of Colorado, University of Illinois, Simon Fraser University, and Georgia State University for helpful comments. Dan Bernhardt gratefully acknowledges financial support from National Science Foundation grant SES-031770. All errors are ours.


We develop an equilibrium model of learning by rational traders to reconcile several empirical regularities: Cross sectionally, most individual speculators lose money; large speculators outperform small speculators; past performance positively affects subsequent trade intensity; most new traders lose money and cease speculation; and performance shows persistence. Learning from trading generates substantial endogenous liquidity, reducing bid–ask spreads and the impact of exogenous liquidity shocks on asset prices, but amplifying the effects of real shocks. Introducing slightly overconfident traders increases bid–ask spreads, hurting all traders. Finally, behavioral theories cannot reconcile all of these empirical regularities.