Trading On Overconfidence

2 May

In Thinking Fast and Slow, Kahneman recounts a time when Thaler, Amos, and he met a senior investment manager in 1984. Kahneman asked, “When you sell a stock, who buys it?”

“[The investor] answered with a wave in the vague direction of the window, indicating that he expected the buyer to be someone else very much like him. That was odd: What made one person buy, and the other person sell? What did the sellers think they knew that the buyers did not? [gs: and vice versa.]”

“… It is not unusual for more than 100M shares of a single stock to change hands in one day. Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.”

Thinking Fast and Slow. Daniel Kahneman

Note: Kahneman is not just saying that buyers and sellers have the same information but that they also know they have the same information.

There is a 1982 counterpart to Kahneman’s observation in the form of Paul Milgrom and Nancy Stokey’s paper on the No-Trade Theorem. “[If] [a]ll the traders in the market are rational, and thus they know that all the prices are rational/efficient; therefore, anyone who makes an offer to them must have special knowledge, else why would they be making the offer? Accepting the offer would make them a loser. All the traders will reason the same way, and thus will not accept any offers.”

This site uses Akismet to reduce spam. Learn how your comment data is processed.