Pouget, Sébastien and Villeneuve, Stéphane (2012) A Mind is a Terrible Thing to Change: Confirmation Bias in Financial Markets. TSE Working Paper, n. 12-306, Toulouse

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Abstract

This paper proposes a dynamic model of financial markets where
some investors are prone to the confirmation bias. Following insights
from the psychological literature, these agents are assumed to amplify
signals that are consistent with their prior views. In a model with
public information only, this assumption provides a rationale for the
volume-based price momentum documented by Lee and Swaminathan
(2000). Our results are also consistent with a variety of other empirically
documented phenomena such as bubbles, crashes, reversals and
excess price volatility and volume. Novel empirical predictions are derived:
i) return continuation should be stronger when biased traders'
beliefs are more extreme, and ii) return continuation should be stronger
after an increase in trading volume. The implications of our model for
short-term quantitative investments are twofold: i) optimal trading
strategies involve riding bubbles, and that ii) contrarian trading can
be optimal in some market circumstances.

Item Type: Monograph (Working Paper)
Language: English
Date: March 2012
Place of Publication: Toulouse
Uncontrolled Keywords: financial markets, psychological biases, confirmation bias, momentum, reversal, bubbles, trading strategies
Subjects: B- ECONOMIE ET FINANCE
Divisions: TSE-R (Toulouse)
Institution: Université Toulouse 1 Capitole
Site: UT1
Date Deposited: 09 Jul 2014 17:25
Last Modified: 02 Apr 2021 15:47
OAI Identifier: oai:tse-fr.eu:25824
URI: https://publications.ut-capitole.fr/id/eprint/15284

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