The power of priors: How confirmation bias impacts market prices

Main Article Content

Michael Cipriano
Thomas S Gruca

Abstract

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. 

Article Details

Section
Articles
Author Biographies

Michael Cipriano, Johnson College of Business and Economics University of South Carolina – Upstate

Assistant Professor of Accounting

Thomas S Gruca, Henry B. Tippie College of Business University of Iowa

Tippie Research Professor of Marketing

References

J Abarbanell and V Bernard ‘Test of Analysts’ Overreaction/Under-reaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior’ Journal of Finance (1992) 47 1181-1207.

C A Anderson, M R Lepper and L Ross ‘The perseverance of social theories: The role of explanation in the persistence of discredited information’ Journal of Personality and Social Psychology (1980) 39 1037-1049.

U Anderson and W Wright ‘Expertise and the explanation effect’ Organizational Behavior and Human Decision Processes (1988) 42 250-269.

N Barberis and R Thaler ‘A survey of behavioral finance’ in G M Constantinides, M Harris and R Stulz (eds) Handbook of the Economics of Finance (Elsevier Science, 2001).

J E Berg, F D Nelson and T Rietz ‘Prediction Market Accuracy in the Long Run’ International Journal of Forecasting (2008) 24(2) 283-298.

G Bodenhausen ‘Stereotypic biases in social decision making and memory: testing process models of stereotype use’ Journal of Personality and Social Psychology (1988) 55 726-737.

C F Camerer ‘Do biases in probability judgments matter in markets? Experimental evidence’ American Economic Review (1987) 77 981-997.

C F Camerer ‘The Rationality of Prices and Volume in Experimental Markets’ Organizational Behavior & Human Decision Processes (1992) 51(2) 237-272.

K Daniel D Hirshleifer and A Subrahmanyam ‘Investor Psychology and Security Market Under- and Overreactions’ Journal of Finance (1998) 53(6) 1839-1886.

P H Ditto, G D Munro, A Apanovitch, J A Scepansky and L K Lockhart ‘Motivated sensitivity to preference-inconsistent information’ Journal of Personality and Social Psychology (1998) 75(1), 53-69.

M J Eames, S M Glover and J J Kennedy, J.J.’Stock Recommendations as a Source of Bias in Earnings Forecasts’ Behavioral Research in Accounting (2006) 18 37-51.

J C Easterwood and S R Nutt ‘Inefficiency in Analysts’ Earnings Forecasts: Systematic Misreaction or Systematic Optimism’ Journal of Finance (1999) 54(5) 1777-1797.

A Elberse ‘The Power of Stars: Do Star Actors Drive the Success of Movies?’ Journal of Marketing (2007) 71 102–120.

A Elberse and B Anand ‘The effectiveness of pre-release advertising for motion pictures: An empirical investigation using a simulated market’ Information Economics & Policy (2007) 19(3/4) 319-343.

J A Elliott, D R Philbrick and C I Wiedman ‘Evidence from Archival Data on the Relation Between Security Analysts’ Forecast Errors and Prior Forecast Revisions’ Contemporary Accounting Research (1995) 11(2) 919-938.

J St B T Evans Bias in human reasoning: causes and consequences (Hillsdale, NJ, Erlbaum, 1989).

E F Fama ‘Market efficiency, long-term returns, and behavioral finance’ Journal of Financial Economics (1998) 49 283-306.

R Forsythe, F Nelson, G R Neumann and J Wright ‘Anatomy of an Experimental Political Stock Market’ American Economic Review (1992) 82 1142-1161.

R Forsythe, T Rietz and T W Ross ‘Wishes, Expectations and Actions: Price Formation in Election Stock Markets’ Journal of Economic Behavior and Organization (1999) 39 83-110.

A R Ganguly, J H Kagel and D V Moser ‘The effects of biases in probability judgments on market prices’ Accounting, Organizations, and Society (1994) 19(8) 675-700.

S J Grossman ‘An introduction to the theory of rational expectations under asymmetric information’ Review of Economic Studies (1981) 48 541–559.

J Hales ‘Directional Preferences, Information Processing and Investors’ Forecasts of Earnings’ Journal of Accounting Research (2007) 45(3) 607-628.

J S Hammersley, K Kadous and A M Magro ‘Cognitive and Strategic Components of the Explanation Effect’ Organizational Behavior and Human Decision Processes (1997) 70(2) 149-158.

J S Hammersley, J.S ‘A Review and Model of Auditor Judgments in Fraud-Related Planning Tasks’ Auditing: A Journal of Practice and Theory (2011) 30(4) 101-128.

J Han and H Tan ‘Investors’ reactions to Management Earnings Guidance: The Joint Effect of Investment Position, News Valence and Guidance Form’ Journal of Accounting Research (2010) 48(1) 81-103.

W Hart, D Albarracin, A Eagly, I Brechan, M Lindberg and L Merrill ‘Feeling validated versus being correct: a meta-analysis of selective exposure to information’ Psychological Bulletin (2009) 135 555-588.

J S Hughes, J Liu and W Su ‘On the Relation between Predictable Market Returns and Predictable Analyst Forecast Errors’ Review of Accounting Studies (2008) 13 266-291.

R Kasznik and M F McNichols ‘Does Meeting Earnings Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices’ Journal of Accounting Research (2002) 40(3) 727-759.

B D Kluger and S B Wyatt ‘Are Judgment Errors Reflected in Market Prices and Allocations? Experimental Evidence Based on the Monty Hall Problem’ Journal of Finance (2004) 59(3) 969-997.

D J Koehler ‘Explanation, Imagination, and Confidence in Judgment’ Psychological Bulletin (1991) 110 499-519.

R E Krider and C B Weinberg ‘Competitive dynamics and the introduction of new products: The motion picture timing game’ Journal of Marketing Research (1998) 35 1–15.

J Liu ‘Market and analysts reactions to earnings news: an efficiency comparison’ (2003) UCLA Working Paper.

C G Lord, M R Lepper and L Ross ‘Biased assimilation and attitude polarization: The effects of prior theories on subsequently considered evidence’ Journal of Personality and Social Psychology (1979) 37 2098-2110.

R E Lucas ‘Expectations and the neutrality of money’ Journal of Economic Theory (1972) 4 103–124.

R S Nickerson ‘Confirmation bias: a ubiquitous phenomenon in many guises’ Review of General Psychology (1998) 2 175-220.

T Odean ‘Volume, volatility, price, and profits when all traders are above average’ Journal of Finance (1998) 53 1887-1934.

D M Pennock, F A Nielsen and C L Giles ‘Extracting Collective Probabilistic Forecasts from Web Game’ in Proceedings of the Seventh ACM SIGKDD International Conference on Knowledge Discovery and Data Mining (New York, 2001) pp 174-183.

C Plott ‘Markets as Information Gathering Tools’ Southern Economic Journal (2000) 67 1-15.

S Pouget, J Sauvagnat and S Villeneuve ‘A Mind is a Terrible Thing to Change: Confirmatory Bias in Financial Markets’ (2014) Toulouse School of Economics Working Paper.

M Rabin and J Schrag ‘First impressions matter: a model of confirmatory bias’ Quarterly Journal of Economics (1999) 114 37-82.

L D Ross, M R Lepper, F Strack and J Steinmetz ‘Social explanation and social expectation: Effects of real and hypothetical explanations on subjective likelihood’ Journal of Personality and Social Psychology (1977) 35(11) 817-829.

A Rubinstein ‘A Theorist’s View of Experiments’ European Economic Review (2001) 45 615-628.

D Scharfstein and J Stein ‘Herd behavior and investment’ American Economic Review (1990) 80 465-479.

H Shefrin Behavioral Corporate Finance: Decisions that Create Value (New York, McGraw-Hill Irwin, 2007)

S J Sherman ‘On the Self-Erasing Nature of Errors of Prediction’ Journal of Personality and Social Psychology (1980) 39 211-21.

S J Sherman, R B Skov, E E Hervitz and C B Stock ’The effects of explaining hypothetical future events: From possibility to probability to actuality and beyond’ Journal of Experimental Social Psychology (1981) 17 142-158.

P E Tetlock ‘Accountability: A social check on the Fundamental Attribution Error’ Social Psychology Quarterly (1985) 48 227-236.

J Thayer ‘Determinants of Investors’ Information Acquisition: Credibility and Confirmation’ The Accounting Review (2011) 86(1) 1-22.

B Trueman ‘Analyst forecasts and herding behavior’ Review of Financial Studies (1994) 7 97-124.

B Tuttle, M Coller and F G Burton ‘An examination of market efficiency: Information order effects in a laboratory market’ Accounting, Organizations, and Society (1997) 22(1) 89-103.

F Teschner, F Wagenschwanz and C Weinhardt ‘Analysis of the Disposition Effect: Asymmetry and Prediction Accuracy’ Journal of Prediction Markets (2012) 7(1), 27-42