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## Risk Attitude, Beliefs Updating and the Information Content of Trades: An Experiment

### Citations

1266 | Milgrom (1985): “Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders
- Glosten, R
(Show Context)
Citation Context ...m the subject’s bias in belief updating. Our data suggest that informational inefficiency is due to the virtual absence of risk neutral behavior but is mitigated by the presence of confirmation bias in the way subjects update their beliefs. Consider the case of a trader who decides on the position to take on a financial asset and who observes a price reflecting public prior belief on the asset fundamentals. Any additional private information the trader may have will be construed to determine his or her posterior belief on the cash flows that the asset will generate. Since the seminal paper by Glosten and Milgrom (1985), it is well known that if both privately informed traders and market makers are risk-neutral Bayesian investors, then the position taken by an informed trader will reflect the sign of his or her private information. Namely, the trader will buy after receiving favorable private information on the asset perspective, and decide to sell if the private information is unfavorable. As a result prices will eventually assimilate all information dispersed in the economy. Outside the risk-neutral world, however, hedging risk matters and the direction of a trade does not necessarily correspond to the sig... |

487 | Experimental Economics
- Davis, Holt
- 1993
(Show Context)
Citation Context ...nd in not trading otherwise (i.e. S-N for negative priors and N-B for positive priors) are more frequent in ME than in LE. Third, for strong (resp. neutral) priors, strategies N-N are less frequent (resp. more frequent) in ME than in LE. Fourth, the frequency of strategies S-B increases in ME.21 Fifth, herd behavior increases in ME. The effect of the ME format on the order flow information content is ambiguous. As illustrated in Table 7, informative strategies rise from 28.17% of all choices in LE to 42.35% in ME. In 20For a presentation of tests of marginal homogeneity, we refer to Davis and Holt (1993) and Agresti (2002). 21With the exception of g = 0. 16 comparison with LE, the frequency of informative strategies in ME increases for strong belief, but decreases for neutral belief. This suggests that when public information is weak, the order flow information content is lower in ME compared to LE. However, for strong prior belief in ME, private information will be better signaled through subjects’ strategies. As a result, the noninformative contingent strategies N-N, B-B and S-S as a function of beliefs display a humped shape as illustrated in Figure 2. 4.2.1 Non-Bayesian updating or framin... |

423 |
The Effects of Financial Incentives in Experiments: A Review and Capital-Labor-Production Framework
- Camerer, Hogarth
- 1999
(Show Context)
Citation Context ...eriment and the lottery experiment. These rounds were randomly selected at the end of the experiment.14 We discarded from our dataset the decisions of 5 subjects who gave more than 3 wrong answers out of the 14 questions in the questionnaire, as we considered these subjects had not understood the main rules of the experiment. The final number of observations was 4,132 for 130 subjects in the main treatment, 1,428 for 42 subjects in the NUR treatment and 850 for 50 subjects in the SME treatment. 12Only 15 rounds for cohorts 1 and 2. 13This device is standard in the literature (see for instance Camerer and Hogarth, 1999; Williams, 2008; Biais et al., 2005) and allow to incentivize participants in their experiments without distorting their risk attitude. 14See the experiment instructions for a precise description of the algorithm determining a subject’s payoffs. 12 4 Experimental Results 4.1 Lottery Experiment In LE, probabilities attached to each possible event are explicitly provided. Thus, for this format an expected utility maximizer’s decision depends only on the shape of his or her utility function and not on the way he or she interprets public and private information. As a consequence, LE provides a si... |

350 | Time and the process of security price adjustment - Easley, O’Hara - 1992 |

163 |
Insider trading, liquidity, and the role of the monopolist specialist.
- Glosten
- 1989
(Show Context)
Citation Context ...on as the past history of trade provides sufficiently strong, but not complete, information regarding the realization of V , the equilibrium is unique and such that all traders submit non-informative orders. This implies that price will stay bounded away from the realization of V .4 While we refer to Avery and Zemsky (1998) and Decamps and Lovo (2006a,b) for the 2The same feature applies in Glosten and Milgrom (1985) and Easley and O’Hara (1992) 3If agents were able to trade a continuum of quantities, risk aversion alone would not be enough to generate market inefficiency. See for instance Glosten (1989) and Vives (1995). 4In other words, heterogeneity of agents and the fact that V ar[V |Ht] remains larger than a positive threshold leads to what Smith and Sørensen (2000) call confounded learning, i.e. a situation where history offers no decisive lesson for anyone and full social learning is never reached. 6 formal proof of these statements, in the following section we will illustrate these findings with a numerical example that reflects the set up of our experiment. 2.2 An illustration of the behavior of a Bayesian expected utility maximizer Consider the following parameters’ values V = 4, V... |

146 | Sequential Sales, Learning and Cascades.
- Welch
- 1992
(Show Context)
Citation Context ...ivate signal and then asked to declare their preferred trading position contingent to the realization of the private signal. In other words, while in LE posterior probability is explicitly provided, in ME subjects have all elements necessary to derive posterior probability. The two formats are designed so that a rational Bayesian expected utility maximizer would find them perfectly equivalent. Implication 5 The behavior of a Bayesian expected-utility maximizer in ME is the same as in LE. 8The literature on rational herding starts with the seminal papers by Bikhchandani and Hirshleifer (1992), Welch (1992) and Banerjee (1992). Herding with endogenous prices has been recently studied in a series of papers, including Avery and Zemsky (1998), Lee (1998), Chari and Kehoe (2004), Decamps and Lovo (2006a,b). See, for instance, Hirshleifer and Teoh (2003) for a survey on herd behavior in capital markets and Chamley (2004) for an extensive study on rational herding. 10 3 Experiment Design We performed our experiment under two different —but in some ways equivalent— formats: ME and LE. Each subject participated in both formats.9 Our main treatment matches the theoretical setup described in Section 2.1 ... |

142 |
Rational Herds. Economic Models of Social Learning
- Chamley
- 2004
(Show Context)
Citation Context ...rational Bayesian expected utility maximizer would find them perfectly equivalent. Implication 5 The behavior of a Bayesian expected-utility maximizer in ME is the same as in LE. 8The literature on rational herding starts with the seminal papers by Bikhchandani and Hirshleifer (1992), Welch (1992) and Banerjee (1992). Herding with endogenous prices has been recently studied in a series of papers, including Avery and Zemsky (1998), Lee (1998), Chari and Kehoe (2004), Decamps and Lovo (2006a,b). See, for instance, Hirshleifer and Teoh (2003) for a survey on herd behavior in capital markets and Chamley (2004) for an extensive study on rational herding. 10 3 Experiment Design We performed our experiment under two different —but in some ways equivalent— formats: ME and LE. Each subject participated in both formats.9 Our main treatment matches the theoretical setup described in Section 2.1 where the random variables V and take value in {4, 12} and {−4, 4}, respectively. We also conducted two control treatments: the Simplified Market Experiment (SME henceforth) and the No-Unlearnable Risk treatment (NUR treatment henceforth) that will be detailed in sections 4.2.1 and 4.3, respectively. Below is a... |

111 | Pathological outcomes of observational learning.
- Smith, Sorensen
- 2000
(Show Context)
Citation Context ... that all traders submit non-informative orders. This implies that price will stay bounded away from the realization of V .4 While we refer to Avery and Zemsky (1998) and Decamps and Lovo (2006a,b) for the 2The same feature applies in Glosten and Milgrom (1985) and Easley and O’Hara (1992) 3If agents were able to trade a continuum of quantities, risk aversion alone would not be enough to generate market inefficiency. See for instance Glosten (1989) and Vives (1995). 4In other words, heterogeneity of agents and the fact that V ar[V |Ht] remains larger than a positive threshold leads to what Smith and Sørensen (2000) call confounded learning, i.e. a situation where history offers no decisive lesson for anyone and full social learning is never reached. 6 formal proof of these statements, in the following section we will illustrate these findings with a numerical example that reflects the set up of our experiment. 2.2 An illustration of the behavior of a Bayesian expected utility maximizer Consider the following parameters’ values V = 4, V = 12, = 4 and p = 0.65. In this instance the fundamental value of the asset can take three values, i.e., v ∈ {0, 8, 16}. In this illustration and throughout the paper,... |

98 | Limited depth of reasoning and failure of cascade formation in the laboratory - Kubler, Weizsacker - 2004 |

63 | Herding and contrarian behavior in financial markets: An internet experiment.
- Drehman, Oechssler, et al.
- 2005
(Show Context)
Citation Context ... In ME, the information content of the order flow is lower than in LE when public prior belief is weak, while it is higher than in LE for stronger public beliefs. Thus, the effect of non-Bayesian updating is to improve information efficiency when the market is clearly bullish or clearly bearish, but to reduce efficiency when the market has no precise orientation. Our paper is related to the experimental literature on information cascade and particularly to Anderson and Holt (1997), Huck and Oechssler (2000), Kubler and Weizsucker (2004), Celen and Kariv (2004), Cipriani and Guarino (2005), Drehman et al. (2005), Alevy et al. (2007), Goeree et al. (2007). Similarly to our work, these papers studied subjects that had to take an investment decisions after receiving some private but partial information about the fundamentals. Differently from our experiment, their subjects traded sequentially. As a result, their subjects’ choices could have been affected by the way subjects interpreted the investment choices previously made by other subjects. In some of these papers, the underlying assumption is that subjects are risk-neutral. Thus, deviations from the risk-neutral rational behavior are identified with ... |

61 | Distinguishing Informational Cascades from Herd Behavior in - Celen, Kariv - 2004 |

55 |
What determines the shape of the probability weighting function under uncertainty. Working paper,
- Kilka, Weber
- 1998
(Show Context)
Citation Context ...our paper is related to the literature on improper Bayesian updating of prior beliefs (see for instance Grether, 1992, Holt and Smith, 2009, among many others). In particular our experiment pins down situations where non-Bayesian individuals do not pose informative orders and therefore do not impact market prices. This result makes echo to Asparouhova et al. (2010) who highlight that individuals who suspect that they do not update correctly are induced to hold more balanced portfolios. More generally, our work is related to the experimental papers in decision theory such as Abdellaoui (2000), Kilka and Weber (2001), Abdellaoui et al. (2005), Abdellaoui et al. (2007). Similarly to our paper these experiments allow the elicitation of subjects’ utility 4 functions and individual probability weights. However, while our data interpretation is based on the expected utility paradigm, these papers take a broader decision theory perspective that encompasses expected utility as a special case. Furthermore, whereas our experiment was designed to have a better understanding of subjects behavior in a Glosten and Milgrom (1985) style economy, their experiment are explicitly designed to recover subject preference. The... |

49 |
Market Crashes and Informational Avalanches.
- Lee
- 1998
(Show Context)
Citation Context ... LE posterior probability is explicitly provided, in ME subjects have all elements necessary to derive posterior probability. The two formats are designed so that a rational Bayesian expected utility maximizer would find them perfectly equivalent. Implication 5 The behavior of a Bayesian expected-utility maximizer in ME is the same as in LE. 8The literature on rational herding starts with the seminal papers by Bikhchandani and Hirshleifer (1992), Welch (1992) and Banerjee (1992). Herding with endogenous prices has been recently studied in a series of papers, including Avery and Zemsky (1998), Lee (1998), Chari and Kehoe (2004), Decamps and Lovo (2006a,b). See, for instance, Hirshleifer and Teoh (2003) for a survey on herd behavior in capital markets and Chamley (2004) for an extensive study on rational herding. 10 3 Experiment Design We performed our experiment under two different —but in some ways equivalent— formats: ME and LE. Each subject participated in both formats.9 Our main treatment matches the theoretical setup described in Section 2.1 where the random variables V and take value in {4, 12} and {−4, 4}, respectively. We also conducted two control treatments: the Simplified Mark... |

37 | Information cascades in the laboratory: Do they occur for the right reasons?
- Huck, Oechssler
- 2000
(Show Context)
Citation Context ...t the virtual absence of risk neutral behavior significantly slows down the convergence of price to fundamentals. In ME, the information content of the order flow is lower than in LE when public prior belief is weak, while it is higher than in LE for stronger public beliefs. Thus, the effect of non-Bayesian updating is to improve information efficiency when the market is clearly bullish or clearly bearish, but to reduce efficiency when the market has no precise orientation. Our paper is related to the experimental literature on information cascade and particularly to Anderson and Holt (1997), Huck and Oechssler (2000), Kubler and Weizsucker (2004), Celen and Kariv (2004), Cipriani and Guarino (2005), Drehman et al. (2005), Alevy et al. (2007), Goeree et al. (2007). Similarly to our work, these papers studied subjects that had to take an investment decisions after receiving some private but partial information about the fundamentals. Differently from our experiment, their subjects traded sequentially. As a result, their subjects’ choices could have been affected by the way subjects interpreted the investment choices previously made by other subjects. In some of these papers, the underlying assumption is ... |

25 | Self-correcting informational cascades.
- Goeree, Palfrey, et al.
- 2007
(Show Context)
Citation Context ... flow is lower than in LE when public prior belief is weak, while it is higher than in LE for stronger public beliefs. Thus, the effect of non-Bayesian updating is to improve information efficiency when the market is clearly bullish or clearly bearish, but to reduce efficiency when the market has no precise orientation. Our paper is related to the experimental literature on information cascade and particularly to Anderson and Holt (1997), Huck and Oechssler (2000), Kubler and Weizsucker (2004), Celen and Kariv (2004), Cipriani and Guarino (2005), Drehman et al. (2005), Alevy et al. (2007), Goeree et al. (2007). Similarly to our work, these papers studied subjects that had to take an investment decisions after receiving some private but partial information about the fundamentals. Differently from our experiment, their subjects traded sequentially. As a result, their subjects’ choices could have been affected by the way subjects interpreted the investment choices previously made by other subjects. In some of these papers, the underlying assumption is that subjects are risk-neutral. Thus, deviations from the risk-neutral rational behavior are identified with lack of Bayesian behavior, when interpretin... |

25 |
The Speed of Information Revelation in a Financial Market Mechanism,
- Vives
- 1995
(Show Context)
Citation Context ...ory of trade provides sufficiently strong, but not complete, information regarding the realization of V , the equilibrium is unique and such that all traders submit non-informative orders. This implies that price will stay bounded away from the realization of V .4 While we refer to Avery and Zemsky (1998) and Decamps and Lovo (2006a,b) for the 2The same feature applies in Glosten and Milgrom (1985) and Easley and O’Hara (1992) 3If agents were able to trade a continuum of quantities, risk aversion alone would not be enough to generate market inefficiency. See for instance Glosten (1989) and Vives (1995). 4In other words, heterogeneity of agents and the fact that V ar[V |Ht] remains larger than a positive threshold leads to what Smith and Sørensen (2000) call confounded learning, i.e. a situation where history offers no decisive lesson for anyone and full social learning is never reached. 6 formal proof of these statements, in the following section we will illustrate these findings with a numerical example that reflects the set up of our experiment. 2.2 An illustration of the behavior of a Bayesian expected utility maximizer Consider the following parameters’ values V = 4, V = 12, = 4 and ... |

21 |
An update on bayesian updating.
- Holt, Smith
- 2009
(Show Context)
Citation Context ...jects’ behavior/rationality play no role. Furthermore, in LE there is no private signal to be interpreted, so the observed difference from the risk-neutral rational behavior contradicts the risk-neutrality premise whereas, for two third of the subjects, it is consistent with either risk averse or risk loving rational behavior. The comparison of LE and ME then allows to insulate the effect of non-Bayesian interpretation of private signal from the effect of risk attitude. Thus, our paper is related to the literature on improper Bayesian updating of prior beliefs (see for instance Grether, 1992, Holt and Smith, 2009, among many others). In particular our experiment pins down situations where non-Bayesian individuals do not pose informative orders and therefore do not impact market prices. This result makes echo to Asparouhova et al. (2010) who highlight that individuals who suspect that they do not update correctly are induced to hold more balanced portfolios. More generally, our work is related to the experimental papers in decision theory such as Abdellaoui (2000), Kilka and Weber (2001), Abdellaoui et al. (2005), Abdellaoui et al. (2007). Similarly to our paper these experiments allow the elicitation ... |

17 | Herd Behaviour and Cascading in Capital Markets: A Review and Synthesis.
- Hirshleifer, Teoh
- 2003
(Show Context)
Citation Context ...ecessary to derive posterior probability. The two formats are designed so that a rational Bayesian expected utility maximizer would find them perfectly equivalent. Implication 5 The behavior of a Bayesian expected-utility maximizer in ME is the same as in LE. 8The literature on rational herding starts with the seminal papers by Bikhchandani and Hirshleifer (1992), Welch (1992) and Banerjee (1992). Herding with endogenous prices has been recently studied in a series of papers, including Avery and Zemsky (1998), Lee (1998), Chari and Kehoe (2004), Decamps and Lovo (2006a,b). See, for instance, Hirshleifer and Teoh (2003) for a survey on herd behavior in capital markets and Chamley (2004) for an extensive study on rational herding. 10 3 Experiment Design We performed our experiment under two different —but in some ways equivalent— formats: ME and LE. Each subject participated in both formats.9 Our main treatment matches the theoretical setup described in Section 2.1 where the random variables V and take value in {4, 12} and {−4, 4}, respectively. We also conducted two control treatments: the Simplified Market Experiment (SME henceforth) and the No-Unlearnable Risk treatment (NUR treatment henceforth) that ... |

16 | Herd behavior in a laboratory financial market.
- Cipriani, Guarino
- 2005
(Show Context)
Citation Context ...nce of price to fundamentals. In ME, the information content of the order flow is lower than in LE when public prior belief is weak, while it is higher than in LE for stronger public beliefs. Thus, the effect of non-Bayesian updating is to improve information efficiency when the market is clearly bullish or clearly bearish, but to reduce efficiency when the market has no precise orientation. Our paper is related to the experimental literature on information cascade and particularly to Anderson and Holt (1997), Huck and Oechssler (2000), Kubler and Weizsucker (2004), Celen and Kariv (2004), Cipriani and Guarino (2005), Drehman et al. (2005), Alevy et al. (2007), Goeree et al. (2007). Similarly to our work, these papers studied subjects that had to take an investment decisions after receiving some private but partial information about the fundamentals. Differently from our experiment, their subjects traded sequentially. As a result, their subjects’ choices could have been affected by the way subjects interpreted the investment choices previously made by other subjects. In some of these papers, the underlying assumption is that subjects are risk-neutral. Thus, deviations from the risk-neutral rational behavi... |

11 |
Financial crisis as herds: Overturning the critiques.
- Chari, Kehoe
- 2004
(Show Context)
Citation Context ...r probability is explicitly provided, in ME subjects have all elements necessary to derive posterior probability. The two formats are designed so that a rational Bayesian expected utility maximizer would find them perfectly equivalent. Implication 5 The behavior of a Bayesian expected-utility maximizer in ME is the same as in LE. 8The literature on rational herding starts with the seminal papers by Bikhchandani and Hirshleifer (1992), Welch (1992) and Banerjee (1992). Herding with endogenous prices has been recently studied in a series of papers, including Avery and Zemsky (1998), Lee (1998), Chari and Kehoe (2004), Decamps and Lovo (2006a,b). See, for instance, Hirshleifer and Teoh (2003) for a survey on herd behavior in capital markets and Chamley (2004) for an extensive study on rational herding. 10 3 Experiment Design We performed our experiment under two different —but in some ways equivalent— formats: ME and LE. Each subject participated in both formats.9 Our main treatment matches the theoretical setup described in Section 2.1 where the random variables V and take value in {4, 12} and {−4, 4}, respectively. We also conducted two control treatments: the Simplified Market Experiment (SME hence... |

9 | Informational cascades with endogenous prices: The role of risk aversion. - Decamps, Lovo - 2006 |

4 | A note on risk aversion and herd behavior in financial markets. - Decamps, Lovo - 2006 |

2 |
Price bubbles in large financial asset markets.
- Williams
- 2008
(Show Context)
Citation Context ...eriment. These rounds were randomly selected at the end of the experiment.14 We discarded from our dataset the decisions of 5 subjects who gave more than 3 wrong answers out of the 14 questions in the questionnaire, as we considered these subjects had not understood the main rules of the experiment. The final number of observations was 4,132 for 130 subjects in the main treatment, 1,428 for 42 subjects in the NUR treatment and 850 for 50 subjects in the SME treatment. 12Only 15 rounds for cohorts 1 and 2. 13This device is standard in the literature (see for instance Camerer and Hogarth, 1999; Williams, 2008; Biais et al., 2005) and allow to incentivize participants in their experiments without distorting their risk attitude. 14See the experiment instructions for a precise description of the algorithm determining a subject’s payoffs. 12 4 Experimental Results 4.1 Lottery Experiment In LE, probabilities attached to each possible event are explicitly provided. Thus, for this format an expected utility maximizer’s decision depends only on the shape of his or her utility function and not on the way he or she interprets public and private information. As a consequence, LE provides a simple framework f... |

1 |
Testing bayesrule and the representative heuristic: some experimental evidence.
- Grether
- 1992
(Show Context)
Citation Context ...about other subjects’ behavior/rationality play no role. Furthermore, in LE there is no private signal to be interpreted, so the observed difference from the risk-neutral rational behavior contradicts the risk-neutrality premise whereas, for two third of the subjects, it is consistent with either risk averse or risk loving rational behavior. The comparison of LE and ME then allows to insulate the effect of non-Bayesian interpretation of private signal from the effect of risk attitude. Thus, our paper is related to the literature on improper Bayesian updating of prior beliefs (see for instance Grether, 1992, Holt and Smith, 2009, among many others). In particular our experiment pins down situations where non-Bayesian individuals do not pose informative orders and therefore do not impact market prices. This result makes echo to Asparouhova et al. (2010) who highlight that individuals who suspect that they do not update correctly are induced to hold more balanced portfolios. More generally, our work is related to the experimental papers in decision theory such as Abdellaoui (2000), Kilka and Weber (2001), Abdellaoui et al. (2005), Abdellaoui et al. (2007). Similarly to our paper these experiments ... |