RFS Advance Access originally published online on August 27, 2008
Review of Financial Studies 2009 22(5):1889-1914; doi:10.1093/rfs/hhn075
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Distinguishing the Effect of Overconfidence from Rational Best-Response on Information Aggregation
Tepper School of Business, Carnegie Mellon University
Send correspondence to Shimon Kogan, Tepper School of Business, Carnegie Mellon University, 5000 Forbes Ave., Pittsburgh, PA 15213, telephone: (412) 268-8501; fax: (412) 268-7357. E-mail: kogan{at}andrew.cmu.edu.
JEL Classification: G12, C92, D83
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Abstract |
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This article studies the causal effect of individuals' overconfidence and bounded rationality on information aggregation by using a new multiperiod game in which agents are rewarded for submitting accurate estimates of an unknown asset's value based on (i) their private information and (ii) others' past estimates. By carrying out laboratory sessions of this game in which subjects' overconfidence is a treatment variable, I find that overconfidence affects the information aggregation process by increasing the dispersion of estimates and decreasing the rate of estimates' convergence. However, even when subjects are not overconfident, qualitatively similar deviations from the fully rational model predictions are observed. I show that this can be explained by subjects' strategic response to errors.
This is an updated version of a paper titled "Distinguishing Bounded Rationality from Overconfidence in Financial Markets—Theory and Experimental Results." I am indebted to my thesis committee Co-Chairs, Jonathan Berk, and Jacob Sagi, and my thesis committee members, Shachar Kariv, John Morgan, Terry Odean, and Nancy Wallace, for their insightful suggestions and continuous support, and I wish to thank the editor, Tobias Moskowitz, and an anonymous referee for their guidance. I would also like to acknowledge helpful comments by George Akerlof, Bob Anderson, Stefano DellaVigna, Vincent Glode, Rick Green, Teck Ho, Botond Koszegi, Lars Lochstoer, Rich Lyons, Ulrike Malmendier, Barbara Mellers, seminar participants at Carnegie Mellon University, Federal Reserve Bank of Boston, Harvard Business School, London Business School, MIT Sloan School of Management, Tel-Aviv University, University of British Columbia, University of California at Berkeley, University of Texas at Austin, University of Utah, Western Finance Association 2005 Meetings, and Yale School of Management for their valuable comments. The financial research support of The Center for Responsible Business, The Dean Witter Foundation, and IBER is gratefully acknowledged.