Arrogance Can Be a Virtue: Overconfidence, Information Acquisition, and Market Efficiency
44 Pages Posted: 11 Aug 2005
In behavioral finance, overconfidence has been established as a prevalent psychological bias, which can make markets less efficient by creating mispricing in the form of excess volatility and return predictability. In this paper, we develop a model where overconfidence causes investors to overinvest in information acquisition where this information may improve market efficiency by driving prices closer to true values. We study the impact of overconfidence on mispricing and information acquisition, comparing their net effect on prices. We derive several novel implications. First, overconfidence generally improves market pricing provided the level of overconfidence is not too high. Pricing can also improve even when overconfidence is arbitrarily high, depending on the amount of private information acquired relative to publicly available information.
Keywords: Behavioral finance, overconfidence, information acquisition, market efficiency, excess volatility
JEL Classification: G14
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