Financial Markets where Traders Neglect the Informational Content of Prices

We present a model of a financial market where some traders are “cursed” when choosing how much to invest in a risky asset, failing to take into account what prices convey about others’ private information. In contrast to rational-expectations equilibrium (REE), the model predicts extensive trade, which can increase in the presence of more private information. The price responds more to public information and less to private information than in REE, causing momentum in asset returns. Also in contrast to REE, cursed traders with more precise private information can be worse off than traders with less precise information. We contrast our results to other models of departures from REE and show that trading volume among cursed agents converges to infinity when the number of agents becomes large, while natural forms of overconfidence predict that volume should remain bounded. Acknowledgments We thank Nick Barberis, Xavier Gabaix, Tristan Gagnon-Bartsch, Josh Schwartzstein, Andrei Shleifer, seminar participants at Columbia, Humboldt, NYU Stern, Wharton, and participants at the Workshop in Bounded Rationality at the Paris School of Economics for helpful comments. We also thank Tristan Gagnon-Bartsch and Tarso Mori Madeira for research assistance.