DP10868 Investment strategy and selection bias: An equilibrium perspective on overconfidence

Author(s): Philippe Jehiel
Publication Date: October 2015
Keyword(s): investment strategy, overconfidence, selection bias
JEL(s): C70, D82, D83, D84
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10868

Prospective investors of new projects consider the returns of implemented projects with similar (observed) attributes and invest if the empirical mean return exceeds the cost. The steady states of such economies result in suboptimal investment decisions due to the selection bias in the sampling procedure. Assuming higher attributes are associated with higher returns, there is systematic overinvestment as compared with the Bayesian benchmark, thereby illustrating that selection bias may explain entrepreneurial overconfidence. Various extensions are considered to illustrate the negative externality that rational investors exert on other investors, the effect of correlation between the attributes considered by various investors, and how trading may be affected by the sampling procedure.