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

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Author Info
Terrance Odean (Haas School of Business, University of California, Berkeley)
Abstract

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.

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Paper provided by EconWPA in its series Finance with number 9803001.

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Length: 49 pages
Date of creation: 12 Mar 1998
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Handle: RePEc:wpa:wuwpfi:9803001

Note: 49 pages, including table and figures. Revised copy of text, Submitted as postscript.
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G - Financial Economics

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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Admati, Anat R. & Pfleiderer, Paul C., 2001. "Noisytalk.com: Broadcasting Opinions in a Noisy Environment," Research Papers 1670r, Stanford University, Graduate School of Business. [Downloadable!]
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  8. Giulio Bottazzi & Giovanna Devetag & Francesca Pancotto, 2009. "Does Volatility matter? Expectations of price return and variability in an asset pricing experiment," LEM Papers Series 2009/02, Laboratory of Economics and Management (LEM), Sant'Anna School of Advanced Studies, Pisa, Italy. [Downloadable!]
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  9. Fellner, Gerlinde & Gueth, Werner & Maciejovsky, Boris, 2001. "Illusion of Expertise in Portfolio Decisions -- An Experimental Approach," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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