Longshots, Overconfidence and Efficiency on the Iowa Electronic Markets
Joyce E. Berg and Thomas A. Rietz
Tippie College of Business, University of Iowa
A basic proposition of behavioral finance is that individual decision-making
biases will manifest themselves in observable financial market phenomena.
While this may help explain financial market anomalies, it is not necessarily the case.
Here, using Iowa Electronic Market (IEM) data, we ask whether the 'longshot bias'
affects market prices. We also ask whether trader overconfidence affects prices.
In context, these give opposing predictions. The IEM is ideal for answering these
questions because it mixes many desirable features from racetrack betting markets
with a closer parallel to naturally occurring financial markets. While
the longshot bias affects many sports betting markets robustly, no such
bias appears here. Nor does overconfidence influence prices at short horizons.
If there is a bias, it results from overconfident traders at long horizons.
While the markets incorporate information efficiently at short horizons,
non-market data indicates some long-horizon inefficiency. When markets
appear inefficient, we calculate Sharpe ratios for static trading strategies
and document returns for dynamic trading strategies to show the economic
content of the inefficiencies.
- Working Paper