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. MODELS OF FINANCIAL MARKETS are often extended by incorporating the imperfections that we observe in real markets. For example, models may not consider transactions costs, an important feature of real markets; so Constantinides ~1979!, Leland ~1985!, and others incorporate transactions costs into their models. Just as the observed features of actual markets are incorporated into models, so too are the observed traits of economic agents. In 1738 Daniel Bernoulli noted that people behave as if they are risk averse. Prior to Bernoulli most scholars considered it normative behavior to value a gamble at its expected value. Today, economic models usually assume agents are risk averse, though, for tractability, they are also modeled as risk neutral. In reality, people are not always risk averse or even risk neutral; millions of people engage in regular risk-seeking activity, such as buying lottery tickets. Kahne-

Dallas, and the First Annual Texas Finance Festival for discussions and comments helpful to the evolution of the paper. Pattarake Sarajoti provided valuable assistance. Mann acknowledges the support of the Charles Tandy American Enterprise Center. A good portion of this work was completed while Locke was on the staff of the U.S. Commodity Futures Trading Commission. However, the views expressed are the authors ’ only and do not purport to represent the views of the Commodity Futures Trading Commission or its staff. Do Professional Traders Exhibit Loss Realization Aversion? Recent evidence (e.g. Odean, 1998a) describes investor behavior that is at odds with traditional economic theory. These alternative behaviors, such as those consistent with the disposition effect or overconfidence, form the basis for recent "behavioral " explanations for asset returns (e.g. Daniel, Hirshleifer and Subrahmanyam 1998a and 1998b, Odean 1998b, and Shumway, 1998). Notably, the evidence of alternative investor behavior is based largely on retail customer accounts- those of amateur traders. In this paper we examine trades by populations of professional futures traders for evidence of activity best described by the “behavioral finance ” literature. The data provide

We examine changes in the stock trading behavior and investment performance of 1,607 investors who switch from phone based to online trading during the period 1992 to 1995. We document that young men who are active traders with high incomes and a preference for investing in small growth stocks with high market risk are more likely to switch to online trading. We also find that those who switch to online trading experience unusually strong performance prior to going online, beating the market by more than two percent annually. After going online, they trade more actively, more speculatively, and less profitably than before-- lagging the market by more than three percent annually. A rational response to reductions in market frictions (lower trading costs, improved execution speed, and greater ease of access) does not explain these findings. The increase in trading and reduction in performance of online investors can be explained by overconfidence augmented by self-attribution bias, the illusion of knowledge, and the illusion of control.

∗This paper is an updated version of a previous working paper, “The Positive Role of Overconfidence and

We experimentally test overconfidence in investment decisions by offering participants the possibility to substitute their own for alternative investment choices.

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Using financial incentives, we study how portfolio choice (how much to invest in a risky asset) depends on three well-known behavioral phenomena: ambiguity aversion, the illusion of control, and myopic loss aversion. We find evidence that these phenomena are present and test how the level of investment is affected by these motivations; at the same time, we investigate whether participants are willing to explicitly pay a small sum of money to indulge preferences for less ambiguity, more control, or more frequent feedback/opportunities to choose the investment level. First, the observed preference for ‘‘control’ ’ did not affect investment behavior and in fact disappeared when participants were asked to actually pay to gain more control. Second, while people were indeed willing to pay for less ambiguity, the level of ambiguity did not influence investment levels. Finally, participants were willing to pay to have more frequent feedback opportunities to change their portfolio, even though prior research has shown that people invest less in risky assets (and earn less) in this case. (JEL B49, C91, D81, G11, G19) I.

This paper focuses on egocentric biases in financial decisions. Subjects first design a portfolio, whereby each combination of assets yields the same expected return and variance of returns. They are then confronted with two alternative portfolios; the average portfolio and the portfolio of one's selected expert. Illusion of expertise prevails if one prefers nevertheless the own portfolio. Using the random price mechanism reveals that most subjects prefer their own portfolio to the average or the expert's portfolio. Illusion of expertise is shown to be stable individually, over alternatives, and for both elicitation methods, willingness to pay and to accept.

This paper is an updated version of a previous working paper, “Capital Budgeting in the Presence of Managerial Overconfidence and Optimism, ” by the same authors. Financial support by the Rodney L. White Center for Financial Research is gratefully acknowledged. The authors would like to thank Andrew Abel,

The experimental evidence on the “endowment effect ” (Kahneman et al. 1990) and the “self serving bias ” in negotiations (Babcok and Loewenstein 1997) suggests that individuals enter a tough state of mind when they have to make a stand vis-avis somebody else. In this work we show how a toughness bias in bargaining may indeed be evolutionary viable. When the inherent toughness of the bargainer is observed by the opponent, this opponent will adjust his behavior accordingly, in a waywhichmayenhancetheactual payoff of the biased bargainer. Suppose, then, that a population consists initially of individuals with different inherent degrees of toughness or softness. They are often matched at random to bargain, and biases which are objectively more successful tend to appear more frequently in the society. We characterize a salient class of bargaining mechanisms under which the population will consist, asymptotically, of individuals with some moderate degree of toughness.