Adaptive Expectations, Confirmatory Bias, and Informational Efficiency

TL;DR

This paper investigates how adaptive expectations and confirmatory bias jointly affect market informational efficiency, revealing that their combination can sometimes improve efficiency despite each bias individually causing deterioration.

Contribution

It introduces a model combining adaptive expectations and confirmatory bias, showing their non-monotonic and sometimes mitigating effects on market efficiency.

Findings

Individual biases worsen informational efficiency

Combined biases can sometimes improve efficiency

Market inefficiency varies non-monotonically with bias parameters

Abstract

We study the informational efficiency of a market with a single traded asset. The price initially differs from the fundamental value, about which the agents have noisy private information (which is, on average, correct). A fraction of traders revise their price expectations in each period. The price at which the asset is traded is public information. The agents' expectations have an adaptive component and a social-interactions component with confirmatory bias. We show that, taken separately, each of the deviations from rationality worsen the information efficiency of the market. However, when the two biases are combined, the degree of informational inefficiency of the market (measured as the deviation of the long-run market price from the fundamental value of the asset) can be non-monotonic both in the weight of the adaptive component and in the degree of the confirmatory bias. For some ranges of parameters, two biases tend to mitigate each other's effect, thus increasing the informational efficiency.