Longshots, Overconfidence and Efficiency on the Iowa Electronic Market

A basic proposition of behavioral finance is that individual decision-making biases affect financial markets. We examine this proposition using data from the Iowa Electronic Market (IEM), a real money market conducted for teaching and research purposes. We ask whether the longshot bias or an overconfidence bias affects market prices. In our market context, these two biases yield opposing predictions. The IEM is ideal for answering these questions because it mixes many desirable research features from betting markets (where the longshot bias is observed) with a closer parallel to naturally occurring financial markets (where researchers look for evidence of overconfidence). 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 indicate 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.