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. 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. Revised copy of text, Submitted as postscript. If you experience problems downloading a file check if you have the proper application to view it first. Information about this may be contained in the File-Format links below. Please be patient as the files may be large.