Biased Learning Creates Overconfidence

The aim of this paper is to develop a multi-period economic model to interpret how the people become overconfident by a biased learning that people tend to attribute the success to their abilities and failures to other factors. The authors suppose that the informed trader does not know the distribution of the precision of his private signal and updates his belief on the distribution of the precision of his knowledge by Bayer’s rule. The informed trader can eventually recognize the value of the precision of his knowledge after an enough long time biased learning, but the value is overestimated which leads him to be overconfident. Furthermore, based on the definition on the luckier trader who succeeds the same times but has the larger variance of the knowledge, the authors find that the luckier the informed trader is, the more overconfident he will be; the smaller the biased learning factor is, the more overconfident the informed trader is. The authors also obtain a linear equilibrium which can explain some anomalies in financial markets, such as the high observed trading volume and excess volatility.