System 1, System 2, and Speculative Trading

Abstract

Loss aversion and overconfidence are arguably the two most studied behavioral biases in finance, and yet often considered having contradictory effects on risk taking. Overconfident investors are generally more prone to take-on risk, whereas loss averse investors tend to be more cautious. We study their marginal impacts on trading. We propose a model in which rational investors and investors who are jointly loss averse and overconfident, disagree over public signals. The proposed theory succeeds to rationalize asymmetries in returns: It generates a positive correlation between volume and aggregate information, a high-volume return premium, positive unconditional skewness and explains cross-sectional variation in skewness at the firm level.

Keywords: Disagreement, Loss Aversion, Overconfidence, Skewness, Trading Volume

JEL Classification: G02, G12