A Mind is a Terrible Thing to Change: Confirmation Bias in Financial Markets

Pouget, Sébastien, Sauvagnat, Julien and Villeneuve, Stéphane (2017) A Mind is a Terrible Thing to Change: Confirmation Bias in Financial Markets. Review of Financial Studies, 30 (6). pp. 2066-2109.

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Official URL: http://tse-fr.eu/pub/31032

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: Article
Language: English
Date: June 2017
Refereed: Yes
Uncontrolled Keywords: financial markets, psychological biases, confirmation bias, momentum, reversal, bubbles, trading strategies
Subjects: B- ECONOMIE ET FINANCE
Divisions: TSE-R (Toulouse), TSM Research (Toulouse)
Site: UT1
Date Deposited: 03 Oct 2016 07:50
Last Modified: 03 Oct 2018 08:37
OAI ID: oai:tse-fr.eu:31032
URI: http://publications.ut-capitole.fr/id/eprint/22414

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