The power of priors: How confirmation bias impacts market prices

One form of confirmation bias is the tendency for people to ignore information that is inconsistent with their current beliefs. While confirmation bias is the subject of both analytical models and experiments in accounting and finance, its effect on market prices has not been studied due to limitations associated with traditional financial markets. In eleven real-money movie box office prediction markets, confirmation bias was induced in all traders via the explanation effect, i.e. a requirement to submit a box office forecast and an explanation prior to trading. When all traders are subject to confirmation bias, market prices do not accurately reflect new, value-relevant information. However, in comparable a set of seven real-money movie prediction markets that included both traders who have not been subject to explanation requirement and those who have, we find efficient incorporation of new information into market prices. This study extends our knowledge of the conditions under which individual trader biases affect market prices and provides potential insights into open questions about forecasting errors among financial analysts.

PUBLIC INFORMATION BIAS AND PREDICTION MARKET ACCURACY

How do prediction markets achieve high levels of accuracy? We propose that, in some situations, traders in prediction markets improve upon publicly available information. Specifically, when there is a known bias in publicly available information, markets provide an incentive for traders to “de-bias” this information. In such a situation, a prediction market will provide a more accurate forecast than the public information available to traders. We test our conjecture using real-money prediction markets for seven local elections in the United States. We find that the prediction market forecasts are significantly more accurate than those generated using the pre-election polls.Previous versions of this paper were presented at the Workshop on The Growth of Gambling and Prediction Markets, the ISBM Conference on Prediction Markets in Marketing: Issues, Challenges and Research Opportunities, the DIMACS Workshop on Markets as Predictive Devices, and the 17th Annual AMA Advanced Research Techniques Forum. The authors thank the participants for their insights which have helped improve this researc

Can Investing Diaries be Hazardous to Your Financial Health?

Business writers and academics have suggested keeping an investing diary to avoid hindsight bias. In the diary, investors justify their predictions of future events, e.g., “This stock will go up because…” Eliminating hindsight bias should improve future returns. However, psychological research on the “explanation effect” suggests that justifying one’s predictions in writing induces overconfidence and, by consequence, reduces current returns. We test these propositions in a set of prediction markets populated by two types of traders: forecasters who completed a required investing diary task and non-forecasters who did not. The portfolios of forecasters were significantly over-invested in securities associated with the forecaster’s prediction. This is consistent with prior psychological research and a clear sign of investor over-confidence. We further find that forecasters with accurate predictions have higher returns than those with inaccurate predictions. However, the returns for forecasters with inaccurate predictions were generally no worse than the returns of the non-forecasters. Our results suggest that while keeping an investing diary may lead to biased portfolios, it does not have an overall negative effect on current returns. Therefore, contrary to expectations, there is not a trade-off between the long-term and short-term effects of an investing diary

The Effects of Sensitization and Habituation in Durable Goods Markets

We develop a model to study the impact of changes in price sensitivity on the firm as it introduces multiple generations of a durable product where unit costs are a convex function of quality. We incorporate the psychological processes of sensitization and habituation into a model of discretionary purchasing of replacement products motivated by past experience. When price sensitivity decreases with each purchase (sensitization), the myopic firm offers a higher quality product at a much higher price with each generation. When price sensitivity increases with each purchase (habituation), the myopic firm engages in price skimming. When sensitization is followed by habituation, the myopic firm eventually provides higher quality than the market is willing to pay for, leading to a steep drop-off in sales and profits. The actions of the forward-looking firm depend on the discount rate. A firm with a low discount rate builds its customer base before offering a higher quality and higher priced product. In contrast, a firm with a high discount rate quickly increases price and quality following the same path to falling profits of the myopic firm. These results provide insight into the firm and consumer behaviors underlying the phenomenon of 'performance oversupply' identified in the innovation literature

Forward modeling of collective Thomson scattering for Wendelstein 7-X plasmas: Electrostatic approximation

In this paper, we present a method for numerical computation of collective Thomson scattering (CTS). We developed a forward model, eCTS, in the electrostatic approximation and benchmarked it against a full electromagnetic model. Differences between the electrostatic and the electromagnetic models are discussed. The sensitivity of the results to the ion temperature and the plasma composition is demonstrated. We integrated the model into the Bayesian data analysis framework Minerva and used it for the analysis of noisy synthetic data sets produced by a full electromagnetic model. It is shown that eCTS can be used for the inference of the bulk ion temperature. The model has been used to infer the bulk ion temperature from the first CTS measurements on Wendelstein 7-X