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...

This paper initiates a study into the century-old issue of market predictability from the perspective of computational complexity. We develop a simple agent-based model for a stock market where the agents are traders equipped with simple trading strategies, and their trades together determine the stock prices. Computer simulations show that a basic case of this model is already capable of generating price graphs which are visually similar to the recent price movements of high tech stocks. In the general model, we prove that if there are a large number of traders but they employ a relatively small number of strategies, then there is a polynomial-time algorithm for predicting future price movements with high accuracy. On the other hand, if the number of strategies is large, market prediction becomes complete in two new computational complexity classes CPP and BCPP, where P NP[O(log n)] BCPP CPP = PP. These computational completeness results open up a novel possibility that the price graph of an actual stock could be suciently deterministic for various prediction goals but appear random to all polynomial-time prediction algorithms. 1

Simonson for making the data available to us and for participating in numerous discussions during the initial Itamar of our research. We also thank Terrance Odean for answering many questions about the investor database. stages

This paper has three main parts. We first present a brief survey of the behavioral anomalies in the finance literature classified as: price and return effects, volume and volatility effects, time series patterns and other miscellaneous effects. For each category, we find that the empirical literature offers a multitude of explanations. We then develop a theoretical information-processing framework to examine the psychology of financial decision making. Many extant behavioral anomalies noted in the finance literature can be derived from this framework. The theoretical framework comprises both cognitive and motivational antecedents of bias in financial decision making. The model posits five stages at which cognitive biases may arise: perception, memory-retrieval, information integration, making a judgment, and behavior. Motivational effects are theorized as either directly affecting the manner in which information is processed, or indirectly moderating the likelihood that cognitive bias...

Many stockholders irrationally believe that high recent market returns predict high future market returns. I argue that the presence of these extrapolative investors can help resolve the equity premium puzzle if the elasticity of intertemporal substitution (EIS) is greater than unity. Extrapolators ’ overreaction to dividend news generates countercyclical expected returns. Rational investors respond by making their consumption growth more procyclical. The equity premium is high because extrapolators believe stocks are a bad hedge and rational investors have high consumption growth covariancewithstocks.ImatchtheU.S.datawitharelativeriskaversionof4andan EIS of 2.

INTRODUCTION Many economists believe that the overall performance of a country's economy is strongly related to the performance of its stock market. Some empirical studies, however, show that this relationship does not necessarily hold. In the sense that stock market performance is highly unpredictable, the movement of stock prices has sometimes been expressed as a random walk process.# Shiller (1989) and DeBondt (1991) have also shown that stock prices are both unpredictable and volatile in the short run. Other empirical studies show that overall economic performance has an influence on the performance of stock prices. Studies by Umstead (1977) and Fama (1981) show that a positive correlation exists between real economic growth and stock prices. Spiro (1990) and Cochrane (1991) find that economic fluctuations influence stock prices and that macroeconomic variables such as real output and the interest rate can explain stock market movement significantly. For over 100 y

How well do financial experts perform? A review of empirical research on performance of analysts, day-traders, forecasters, fund managers, investors, and stockbrokers 1