Bank of Lithuania
Overconfidence and Correlated Information Structures

Overconfidence and Correlated Information Structures

Overconfidence and Correlated Information Structures

This paper analyzes a model of multiple overconfident traders submitting market orders where traders’ private information is subject to correlated errors, as well as its extension to endogenous information. We consider two standard types of overconfidence: overconfidence in own signals and underconfidence in others’ signals. The analyses on the effects of overconfidence on traders’ behavior and the equilibrium price suggest that these effects are richer than our typical understanding of overconfidence focusing on its positive effect on trading volume as follows: First, trading volume may increase or decrease with overconfidence depending on its type. Second, these different types of overconfidence may differ radically on the patterns of trading volume and price informativeness with respect to the number of traders. Third, overconfidence can cause equilibrium multiplicity in information acquisition.

JEL Classification: G11, G14, G4
Keywords: Overconfidence; Disagreement; Strategic trading; Information aggregation; Efficient market hypothesis

Overconfidence, Disagreement, Strategic trading, Information aggregation, Efficient market hypothesis