Volume, Volatility, Price, and Profit When All Traders Are Above Average

TLDR

Overconfidence among market participants distorts financial markets, with effects varying by who is overconfident and how information is distributed. The study investigates how overconfidence among price‑taking traders, a strategic insider, and risk‑averse market makers shapes market outcomes. Overconfidence raises trading volume and market depth while reducing overconfident traders’ utility; its impact on volatility and price quality depends on the overconfident agent, with markets underreacting to rational and highly relevant information and overreacting to salient, anecdotal signals.

Abstract

People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price‐taking traders, a strategic‐trading insider, and risk‐averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.