Speculating against an overconfident market

We distinguish two components of self-confidence in a financial market: private self confidence measures the self-confidence of speculators, while public self-confidence measures the self-confidence they attribute to their competitors. We study how independent changes in these components affect the trading strategies. We calculate the unique linear symmetric equilibrium and the major indicators of market performance in a financial market with imperfect competition where investors submit limit orders. In addition to providing a partial explanation for the excess volatility of asset prices and for trading volume unexplained by the arrival of new information, our model highlights the differences between the effects of biases in public versus private self-confidence. © 2002 Elsevier Science B.V. All rights reserved.