We propose a theory of securities market under- and overreactions based on two well-known psychological biases: investor overconfidence about the precision of private information; and biased self-attribution, which causes asymmetric shifts in investors ’ confidence as a function of their investment outcomes. We show that overconfidence implies negative long-lag autocorrelations, excess volatility, and, when managerial actions are correlated with stock mispricing, public-event-based return predictability. Biased self-attribution adds positive short-lag autocorrela-tions ~“momentum”!, short-run earnings “drift, ” but negative correlation between future returns and long-term past stock market and accounting performance. The theory also offers several untested implications and implications for corporate fi-nancial policy. IN RECENT YEARS A BODY OF evidence on security returns has presented a sharp challenge to the traditional view that securities are rationally priced to re-f lect all publicly available information. Some of the more pervasive anoma-

We review studies conducted by ourselves and coauthors that document a "self-serving " bias in judgments of fairness and demonstrate that the bias is an important cause of impasse in negotiations. We discuss experimental evidence showing that (a) the bias causes impasse; (b) it is possible to reduce impasses by debiasing bargainers; and (c) the bias results from selective evaluation of information. We also review results from a field study of negotiations between teachers ' unions and school boards in Pennsylvania that both documents the fairness bias in a naturalistic setting and demonstrates its impact on strikes. A major unsolved riddle facing the social sciences is the cause of impasse in negotiations. The consequences of impasse are evident in the amount of private and public resources spent on civil litigation, the costs of labor unrest, the psychic and pecuniary wounds of domestic strife, and in clashes between religious, ethnic and regional groups. Impasses in these settings are not only pernicious, but somewhat paradoxical since negotiations typically unfold over long periods of time, offering ample opportunities for interaction between the parties. Economists, and more specifically, game theorists, typically attribute delays in settlement to incomplete information. Bargainers possess private information about factors such as their alternatives to negotiated agreements and costs to delay, causing the bargainers to be mutually uncertain about the other side's reservation value. Uncertainty produces impasse because bargainers use costly delays to signal to

Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.”

Award at the 2005 European Finance Association Meeting, to the retail broker and discount

In a duopoly model of informed speculation, we show that overconfidence may strictly dominate rationality since an overconfident trader may not only generate higher expected profit and utility than his rational opponent, but also higher than if he were also rational. This occurs because overconfidence acts like a commitment device in a standard Cournot duopoly. As a result, for some parameter values the Nash equilibrium of a two-fund game is a Prisoner's Dilemma in which both funds hire overconfident managers. Thus, overconfidence can persist and survive in the long run. 2 The rational expectations hypothesis implies that economic agents make decisions as though they know a correct probability distribution of the underlying uncertainty. According to the traditional view (Alchian (1950) and Friedman (1953)), the rational expectations hypothesis is empirically plausible because rational beliefs are better able to survive the market test than irrational beliefs. Yet, the empirical liter...

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This paper explains why seemingly irrational overconfident behavior can persist. Information aggregation is poor in groups in which most individuals herd. By ignoring the herd, the actions of overconfident individuals (“entrepreneurs”) convey their private information. However, entrepreneurs make mistakes and thus die more frequently. The socially optimal proportion of entrepreneurs trades off the positive information externality against high attrition rates of entrepreneurs, and depends on the size of the group, on the degree of overconfidence, and on the accuracy of individuals ’ private information. The stationary distribution trades off the fitness of the group against the fitness of overconfident individuals. Starting any company is really hard to do, so you can’t be so smart that it occurs to you that it can’t be done.

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially

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This paper is an investigation into the determinants of asymmetries in stock returns. We develop a series of cross-sectional regression specifications which attempt to forecast skewness in the daily returns of individual stocks. Negative skewness is most pronounced in stocks that have experienced: 1) an increase in trading volume relative to trend over the prior six months; and 2) positive returns over the prior thirty-six months. The first finding is consistent with the model of Hong and Stein (1999), which predicts that negative asymmetries are more likely to occur when there are large differences of opinion among investors. The latter finding fits with a number of theories, most notably Blanchard and Watson’s (1982) rendition of stockprice bubbles. Analogous results also obtain when we attempt to forecast the skewness of the aggregate stock market, though our statistical power in this case is limited.