Journal of Financial Markets 1 (1998) 353Ð383 Aggressiveness and survival of overconÞdent traders

This paper explicitly models investor behaviour in Þnancial markets allowing for traits linked to a notion of imperfect rationality. We study an extreme form of posterior overconÞdence where some risk neutral investors overestimate the precision of their private information. They compete in market orders with another group of informed traders who have rational expectations. The participation of overconÞdent traders in the market leads to higher transactions volume, larger depth, more volatile and more informative prices. More importantly, such traders may make higher expected proÞts than rational ones and may even earn more than if they switched to rational behaviour. Their unconscious commitment to aggressive trading o¤ers them a ÔÞrst mover advant-ageÕ. I consider an extension with risk averse market makers and Þnd that the nature of results depends on whether exogenous noise trading exists. ( 1998 Elsevier Science B.V. All rights reserved