Distinguishing Bounded Rationality from Overcondence in Financial Markets - Theory and Experimental Results1

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, price errors and volatility 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 observationally equivalent 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 about 40% of excess volume is attributable to strategic response to errors, while the remaining is attributable to overcon…dence. If one looks at price errors or price volatility, similar results are obtained. Further, we show that the distribution of estimated individual level overcon…dence is linked to the observed price reversals, present only in the overcon…dence-induced sessions. Additional …ndings are discussed.