Overcondence and prediction quality of information marketsmarkets

In the case that information aggregation in a market strictly follows the ecient market hypothesis, the market prices' prediction quality will only be subject to the quality of individual information, as it will be eciently revealed in the trading process.

Yet, Section 4.4 has highlighted research results from the domain of behavioral economics showing that activities and outcomes in experimental and real-world markets often di-verge from the predictions of the ecient-market hypothesis. Among other outcomes, speculative trading and information cascades may increase market error when agents do not update or reveal information rationally via trading (Glaser et al. 2003).

The rst experiment revealed that individual biases can signicantly inuence trading behavior, independent of individual information quality. Weber (2000) highlights that participants' information quality and trading behavior needs to be synchronously consid-ered as a central subject-based driver of market prices' predictive quality. We therefore focused the development of our hypotheses on the inuence of information quality, trad-ing behavior and the interaction of these two drivers on market prediction quality.

The argument that more informed traders increase market prediction quality

is economically straightforward. Better information quality among market participants leads to more informed trades, which reduces market price error (Fama 1970). Except for the theoretical case where perfect information among all traders prevents any trad-ing activity (Milgrom and Stokey 1982), the presence of more information will generate better market predictions.

In our experiment, we control the manipulated subjects' information by providing the treated subjects with identical diagnostic cues regarding the information market pre-diction tasks. Previous research has argued that overcondent individuals will be less likely to absorb diagnostic cues if those cues diverge from personal expectations (Hay-ward et al. 2006). In our case, it is thought that this can induce greater variance and error in individual predictions before the market by overcondent subjects. Yet, the experimental setup presents the diagnostic cues jointly with the tasks, which supports hindsight among treated subjects. As they are not required to express task-related ex-pectations before the market starts, all treated subjects are expected to form beliefs as if the newly-acquired information had been previously possessed (Astebro et al. 2007;

Cassar and Craig 2009). As a result, we can expect their individual predictions before the market to be relatively homogeneous, with variance lower than noise traders' individ-ual predictions and independent of the treatment condition. Consequently, the qindivid-uality of treated subjects' predictions is not expected to increment average market prediction errors but rather keep them within the boundaries of their informational background.

Noise traders, on the other hand, do not receive diagnostic cues, which would reduce individual prediction errors and variance in prediction error among those participants.

Noise traders are thus expected to exhibit highly uninformed individual predictions with large variances in prediction quality. Additionally, the noise traders do not have access to diagnostic information during the market, except for what they can extract from market signals. The information market prices are thus expected to suer in prediction quality if these uninformed individuals reveal their information via trading, inuencing market prices.

Hypothesis 5 Noise traders' average individual prediction errors before the market will increase average market-prediction error.

The rst experiment demonstrated that that the level of individual condence can sig-nicantly impact individual trading behavior. Trading behavior describes how subjects trade in the market and how they respond to other traders' market signals. In partic-ular, overcondent subjects were more likely to act early in information markets, trade more stocks per transaction, and more strongly oppose market signals. Additionally, the

post-market predictions showed that overcondent individuals are less likely to update private predictions based on market signals.

Previous research has explored how and why overcondence and subsequent trading be-havior inuences the eciency of information aggregation in markets.

On the one hand, focus can be placed upon the direct impact of overcondent traders' behavior on market prices and their predictive quality. Theoretical work has shown that the presence of overcondent traders increases market price volatility (Benos 1998; Caballé and Sákovics 2003; Odean 1998). Market prices are more likely to uctu-ate because overcondent traders trade more aggressively. The label of aggressiveness can be reected in the strength of market signals sent by overcondent traders, such as the amount of shares they trade per transaction (Benos 1998; Caballé and Sákovics 2003) or their overall trading volumes (Odean 1998). As previous research and the rst experiment have shown, overcondent traders overvalue the predictive quality of private information, which a creates stronger reaction to market signals that contradict their beliefs (Glaser et al. 2003). The rst experiment demonstrated the increase in aggres-siveness via increased trading volumes, earlier trading and stronger opposition to market signals that oppose private information.

However, results from existing research on the direct impact of overcondent traders' behavior on the predictive quality of market prices are ambiguous (Glaser et al. 2003).

On the one hand, Benos (1998) have provided a model in which all traders are well informed. Overcondent traders increase liquidity and market depth, which leads to quicker convergence and ecient market pricing. On the other hand, Nöth and Weber (2003) have produced experimental evidence showing that overcondent traders' behav-ior negatively inuences market price quality. Even when relatively long sequences of market signals favor outcomes that oppose overcondent subjects' private evaluations, they will too often break such information cascades, thus reducing the aggregate quality of the market signals.

In the context of our experiment, the direct impact of overcondent traders' more ag-gressive trading behaviors on market prediction quality is ambiguous. They are expected to more strongly oppose ill-informed noise traders because they would be less likely to absorb those signals as valid information, which could increase the amount of correcting market signals. Yet, they would also be more likely to strongly oppose the signals of the other well-informed overcondent traders. This could prevent both treated subjects from learning from the respective interpretations. In summary, it is unclear whether

overcondent traders' behavior will directly impact market prediction quality.

On the other hand, focus can be placed upon the indirect impact of overcondent traders' behavior on market prediction quality via the reaction to their signals and subsequent action of other traders.

First, theoretical insight from signal detection theory has helped us understand how ag-gressive trading behavior by overcondent subjects yields dierent signal perception and processing by noise traders than less aggressive trading behavior by low-condence sub-jects. More aggressive trading increases market price volatility. Experimental evidence based on signal detection models shows that higher volatility in the values of sequential signals decreases subjects' performance in extracting valid information from these sig-nals (Macmillan 2002; Gold et al. 2004). Subjects are less likely to identify underlying commonalities when signal values vary more strongly.

In a context more closely related to information markets, Daniel et al. (1998) built his nancial market model with overcondent traders on the assumption that overcondent traders' market signals exhibit a larger proportion of noisiness because they do not suf-ciently consider previously revealed information.

These theoretical assumptions nd support in cognitive and business-related experi-ments. In a meta-analysis of 13 social learning games, Weizsäcker (2010) shows that lack of agreement in other participants' signals makes it more dicult for subjects to make correct inferences from these signals, thus negatively inuencing decision quality.

Kremer et al. (2011) nd support for the system neglect hypothesis in a forecasting experiment by Massey and Wu (2005), according to whom, individuals place too much emphasis to signals they receive relative to the system that generates the signals. Trans-lated to the information market, subjects may pay too little attention to the information that underlies the overcondent subjects' trading behavior.

Noise traders may furthermore emulate treated individuals' trading behavior. It has fre-quently been demonstrated in social game experiments that the behavioral dierences of manipulated subjects are reected in the behavior of untreated subjects in interactive scenarios (Camerer and Fehr 2006). This has mainly been attributed to social interaction concepts such as reciprocity and conditional cooperation (Engel et al. 2011). Subjects are sensitive to other group members' behavior and tend to mimic it, independent of potential consequences.

In the context of market behavior, this can augment noise traders' inability to learn from market signals in the case that overcondent traders are present. Noise traders

will be less likely to absorb overcondent subjects superior information before engaging in trading if they mimic their aggressiveness (Bikhchandani et al. 1998).

To summarize, overcondent participants' trading behavior induces noise trader reac-tions that positively impact their inuence on market errors. Such a relareac-tionship hence augments the positive relationship between noise traders' individual prediction errors and the information market prediction quality.

Hypothesis 6 The presence of overcondent traders will increase the positive eect of noise traders' average individual prediction errors before the market on overall market prediction error.

Individual post-market predictions

In our experiment, post-market predictions are submitted directly after the markets have nished. To make these predictions, treated subjects draw from the diagnostic informa-tion received previously, their subsequent pre-market predicinforma-tions, and the signals they have gathered during trading.

Treated subjects engage in a costly cognitive task to analyze the provided pieces of in-formation and transform them into private estimations. The inin-formation provided and subsequent private predictions are represented by a very limited set of four distinct val-ues during this task. The three valval-ues provided as diagnostic information are externally labeled as valid information. Treated subjects process and aggregate these values pri-vately to form private pre-market evaluations.

In contrast, subjects do not perceive market signals as similarly valid sources of in-formation. First, subjects have no information about the processing capability of the other participants. Previous empirical work has shown that participants' information market trading is impacted signicantly more by predictions from direct and determin-istic information sources, e.g. from colleagues in geographic proximity who give specic suggestions and provide specic values, than by market prices (Cowgill et al. 2008).

Lack of information about others' capabilities leads to the underestimation of those ca-pabilities (Camerer and Lovallo 1999). In a related experiment, Radzevick and Moore (2011) demonstrated experimentally that subjects are more likely follow unambiguous suggestions. Second, the market will provide signals that do not reect the provided in-formation because noise traders cannot draw from that inin-formation. This will decrease the likelihood that the treated subjects will update private estimations based on market signals, as discussed in the market-related hypothesis. They would have reason to doubt the validity of market signals in the light of their private information.

The discrepancy in the perceived quality of signals before and during the market em-phasizes the relative importance of private pre-market predictions in the post-market predictions of treated subjects. Market signals will have less relevance for forming post-market predictions for treated subjects. Furthermore, overcondent subjects are even more likely to draw inferences for post-market predictions from their market pre-dictions (Deaves et al. 2009). Underlined by the results of the rst experiment (see Section 7.4), overcondent subjects are less likely to update their beliefs than subjects in the low-condence condition. This may increase the positive inuence of pre-market errors on post-market errors for overcondent traders. Overcondent subjects are more likely to maintain particularly high pre-market errors because they do not consider mar-ket signals, even in the case that they would prove helpful.

Hypothesis 7 Treated subjects' post-market prediction errors will be positively correlated with their pre-market prediction errors.

Hypothesis 8 Overcondence treatment will increase the positive relationship between individual pre-market error and individual post-market error in treated subjects.

In our experiment, noise traders did not receive diagnostic information before the mar-ket. As a consequence, they were expected to perceive their private estimations as both less valid overall and less valid relative to market signals and compared to treated sub-jects. This would increase their absolute and relative sensitivity to market signals for use in forming predictions, as discussed with the market-related hypothesis. They would be more likely to update beliefs because, compared to treated subjects, noise traders would be less inclined to engage in biased hypothesis testing based on previously processed information that they ought to deem valid. They would not possess diagnostic infor-mation that could narrow the interval of plausible private evaluations or prevent them from dismissing market signals as uninformative.

Two consequences would be expected to arise from this. First, the improvement of noise traders' predictions between markets would depend primarily on their pre-market prediction error. The higher their pre-market errors, the more likely they would be to improve predictions after updating beliefs because the market would have provided them with signals to allow for prediction improvement. They would be able to harness the superior information of the treated subjects to improve their own private predictions.

Second, the market error would signicantly inuence the quality of their post-market evaluations. As they would indeed draw information from market prices to update their

beliefs, higher market errors would limit noise traders' ability to improve their predic-tions from pre-market errors.

Hypothesis 9 Noise traders' post-market prediction errors will be positively correlated with their pre-market errors.

Hypothesis 10 Noise traders' post-market prediction errors will be positively correlated with overall market error.

8.2. Experimental design

8.2.1. Participants

We recruited 136 graduate engineering students from the same university as in the rst experiment to participate in the information markets. The students were part of the consecutive class that followed a year after the participants of the rst laboratory experi-ment. This ensured that subjects had similar educational backgrounds and demographic characteristics but no knowledge about the previous experiment. All held bachelors' de-grees in engineering disciplines and were currently enrolled in business administration courses at Hamburg University of Technology. The average age was 23 and 20 percent were females. We again issued pre and postexperimental questionnaires to evaluate -nancial risk attitude, product-domain involvement, and individual predictions regarding the innovation-evaluation tasks. This was particularly necessary to evaluate the eect of participation on the prediction quality in the innovation evaluation tasks. After the market exercise, we presented each subject with a similar information market quiz to test their understanding of incentives and the information market in general. This time, all 136 subjects participated successfully in the experiment.

8.2.2. Innovation evaluation tasks

The second experiment was aimed at investigating the relationship between overcon-dence and prediction error in the context of innovation evaluation. For this, we required innovation evaluation tasks where the outcome was truly unknown at the time of the prediction so that the information market prices and individual predic-tions could be analyzed in terms of predictive quality. Hence, the experiment required the application of tasks that relate closely to innovation evaluation, featured unknown future outcomes at the time of prediction, and still allowed for us to provide diagnostic information. Similar to the rst experiment, the evaluation tasks were related to success

potential and marketing-related characteristics of innovation products, such as market share developments of innovative products and product characteristics.

We partnered with GfK Retail & Technology GmbH, the global leader in tracking the sales of technology-based consumer goods such as domestic appliances, oce technol-ogy, consumer electronics, and communication technoltechnol-ogy, to dene relevant prediction tasks for innovative products in the category of mobile computing and derive diagnostic information based on their expertise. At the same time, the company's market data al-lowed us to evaluate prediction errors after the markets had nished and the prediction events had occurred to test our hypotheses.

We chose the mobile computing product category for three reasons. First, that product category is highly dependent on valid innovation evaluation, since product de-velopment costs and failure rates can be very high (Eisenhardt and Tabrizi 1995). Second, the subject group had been highly exposed to the innovative consumer electronic prod-ucts upon which we focused the evaluation tasks, both as frequent users of novel devices but also in the academic context of innovation management and marketing courses. Fi-nally, high-technology companies such as consumer electronics rms are considered a similarly attractive future employer for German engineering students as the automobile industry, with companies such as Google and Apple ranking on a par with leading au-tomobile manufacturers in Germany (Trendence Institut 2011). Thus, our subjects were expected to exhibit a suciently high degree of product involvement and were initially assumed to be capable of making informed predictions.

We developed a set of 16 innovation-related questions ranging from the assessment of potential market success for specic tablet-PC products such as the Apple iPad, to eval-uating the price drops of new technologies such as SSD hard drives.¹

Analogous to the rst experiment, 10 of the 16 tasks were randomly drawn for use in the manipulation treatment to induce dierent condence levels via false feedback. The remaining six tasks were then used in the information markets.

The three pieces of additional information per information market period were devel-oped in collaboration with market experts. We ensured the diagnosticity of the presented information by consulting with senior GfK market experts and by drawing on the company's internal forecasting systems. Thus, the information can be considered diagnostic from an objective perspective. It was furthermore emphasized while devel-oping the cues that the information pieces should add information quality if presented

1The complete set of evaluation questions and information market prediction tasks are included in the Appendix.

sequentially. After having generated the information market questions and the pieces of information, we conducted an informal pre-test with a non-related lecture group of 50 industrial-engineering master students who had similar characteristics but who would not be participating in the information markets. The pre-test showed that the informa-tion given led to better individual predicinforma-tions and that individual predicinforma-tions improved with the amount of information received, when using GfK forecasts as proxies for pre-diction outcomes.

8.2.3. Implementation

The experiment was again executed using z-Tree, a software framework for programming economic experiments (Fischbacher 2007). Figure 8.1 depicts the design of the second

Figure 8.1.: Design for the second experiment, by experimental setting: Number of cases by treatment and experimental setting

experiment and the expected number of cases per experimental cell, based on the subject sample size and market repetitions per trading group. The gure visualizes the second experiment as two 2 X 1 experiments: rst, the basic experimental setting in which diagnostic information is provided free of charge to treated participants, and then the extended scenario, in which the subjects have the opportunity to acquire the information