Under- and Over- Reaction from Relative and Aggregate Overconfidence

This paper offers a continuous time, general equilibrium model where a risky asset is traded among risk-averse overconfident investors. Two kinds of overconfidence are introduced: investors exhibit relative overconfidence if each investor believes her model is better than others’ and aggregate overconfidence if they believe signals have more information content than those in the true model. Relative overconfidence creates market price underreaction, while aggregate overconfidence generates overreaction. Excess trading volume is generated from relative overconfidence but not aggregate overconfidence. High equity premium and excess price change volatility result from aggregate overconfidence in the early stages of investors’ extrapolation of information, but not in the steady state. JEL Codes: D80, D82, D84, G10, G11, G12, G14.