This paper proposes a dynamic model of financial markets where
some investors are prone to the confirmation bias. Following insights
from the psychological literature, these agents are assumed to amplify
signals that are consistent with their prior views. In a model with
public information only, this assumption provides a rationale for the
volume-based price momentum documented by Lee and Swaminathan
(2000). Our results are also consistent with a variety of other empirically
documented phenomena such as bubbles, crashes, reversals and
excess price volatility and volume. Novel empirical predictions are derived:
i) return continuation should be stronger when biased traders'
beliefs are more extreme, and ii) return continuation should be stronger
after an increase in trading volume. The implications of our model for
short-term quantitative investments are twofold: i) optimal trading
strategies involve riding bubbles, and that ii) contrarian trading can
be optimal in some market circumstances
