empirical literature can reasonably be viewed as being responsive to mispric-
ing, and have the abnormal return pattern discussed above. Subsection 2.B.4
offers several additional implications about the occurrence of and price pat-
terns around corporate events and for corporate policy that are either
untested or have been confirmed only on a few specific events.
The empirical psychology literature reports not just overconfidence, but
that as individuals observe the outcomes of their actions, they update their
confidence in their own ability in a biased manner. According to attribution
theory(Bem 1965), individuals too strongly attribute events that confirm
the validity of their actions to high ability, and events that disconfirm the
action to external noise or sabotage. (This relates to the notion of cognitive
dissonance, in which individuals internally suppress information that con-
flicts with past choices.)
If an investor trades based on a private signal, we say that a later public
signal confirmsthe trade if it has the same sign (good news arrives after a
buy, or bad news after a sell). We assume that when an investor receives con-
firming public information, his confidence rises, but disconfirming informa-
tion causes confidence to fall only modestly, if at all. Thus, if an individual
begins with unbiased beliefs, new public signals on averageare viewed as
confirming the private signal. This suggests that public information can trig-
ger further overreaction to a preceding private signal. We show that such
continuing overreaction causes momentum in security prices, but that such
momentum is eventually reversed as further public information gradually
draws the price back toward fundamentals. Thus, biased self-attribution im-
plies short-run momentum and long-term reversals.
The dynamic analysis based on biased self-attribution can also lead to a
lag-dependent response to corporate events. Cash flow or earnings surprises
at first tend to reinforce confidence, causing a same-direction average stock
price trend. Later reversal of overreaction can lead to an opposing stock price
trend. Thus, the analysis is consistent with both short-term postannounce-
ment stock price trends in the same same direction as earnings surprises and
later reversals.
In our model, investors are quasi-rational in that they are Bayesian opti-
mizers except for their overassessment of validprivate information, and
their biased updating of this precision. A frequent objection to models that
explain price anomalies as market inefficiencies is that fully rational in-
vestors should be able to profit by trading against the mispricing. If wealth
flows from quasi-rational to smart traders, eventually the smart traders
may dominate price-setting. However, for several reasons, we do not find
this argument to be compelling, as discussed in the conclusion.
Several other papers have modeled overconfidence in various contexts.
Hirshleifer, Subrahmanyam, and Titman (1994) examined how analyst/
traders who overestimate the probability that they receive information be-
fore others will tend to herd in selecting stocks to study. Kyle and Wang
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