Distinguishing Overcondence from Rational Best-Response in Markets1

This paper studies the causal e¤ect of individuals’overcon…dence and bounded rationality on asset markets. To do that, we combine a new market mechanism with an experimental design, where (1) players’interaction is centered on the inferences they make about each others’ information, (2) overcon…dence in private information is controlled by the experimenter (i.e., used as a treatment), and (3) natural analogs to prices, returns and volume exist. We …nd that in sessions where subjects are induced to be overcon…dent, volume and price error analogs are higher than predicted by the fully-rational model. However, qualitatively similar results are obtained in sessions where there is no aggregate overcon…dence. To explain this, we suggest an alternative possibility: participants strategically respond to the errors contained in others’ actions by rationally discounting the informativeness of these actions. Estimating a structural model of individuals’decisions that allows for both overcon…dence and errors, we are able to separate these two channels. We …nd that a substantial fraction of excess volume and price error analogs is attributable to strategic response to errors, while the remaining is attributable to overcon…dence. Further, we show that price analog exhibit serial autocorrelation only in the overcon…dence-induced sessions.