Longshots, Overconfidence and Efficiency on the Iowa Electronic Markets
Joyce E. Berg and Thomas A. RietzWorking Paper
Tippie College of Business, University of Iowa
- Abstract
A basic proposition of behavioral finance is that individual decision-making biases will manifest themselves in observable financial market phenomena. While this may help explain financial market anomalies, it is not necessarily the case. Here, using Iowa Electronic Market (IEM) data, we ask whether the 'longshot bias' affects market prices. We also ask whether trader overconfidence affects prices. In context, these give opposing predictions. The IEM is ideal for answering these questions because it mixes many desirable features from racetrack betting markets with a closer parallel to naturally occurring financial markets. While the longshot bias affects many sports betting markets robustly, no such bias appears here. Nor does overconfidence influence prices at short horizons. If there is a bias, it results from overconfident traders at long horizons. While the markets incorporate information efficiently at short horizons, non-market data indicates some long-horizon inefficiency. When markets appear inefficient, we calculate Sharpe ratios for static trading strategies and document returns for dynamic trading strategies to show the economic content of the inefficiencies. - Working Paper
