Are Judgment Errors Reflected in Market Prices and Allocations? Experimental Evidence Based on the Monty Hall Problem

Abstract

The question of whether individual judgment errors survive in market equilibrium is an issue that naturally lends itself to experimental analysis. Here, the Monty Hall problem is used to detect probability judgment errors both in a cohort of individuals and in a market setting. When all subjects in a cohort made probability judgment errors, market prices also ref lected the error. However, competition among two biasfree subjects was sufficient to drive prices to error-free levels. Thus, heterogeneity in behavior can be an important factor in asset pricing, and further, it may take few bias-free traders to make asset prices bias-free.IN RECENT YEARS, behavioral researchers have challenged the joint hypotheses of efficient markets and the idea that average (excess) returns are solely rewards for risk, suggesting that these are deficient for interpreting capital market data (De Bondt and Thaler (1985), Shleifer (2000), Hirshleifer (2001)). They argue that individual cognitive errors are useful in interpreting marketwide anomalies, presupposing that individual judgment errors aggregate into similar marketwide errors. Other researchers instead maintain that individual judgment errors do not materially affect markets in equilibrium. Rubinstein (2001, p. 26) summarizes: "Some adherents of behavioral finance begin sensibly enough with the results of convincing experiments that show human beings are irrational in certain specific systemic ways. But then comes the hand waving as they try to extend the results to the much more complex, long-lasting, repetitive and subtle environment of the market. This extension requires a big leap of faith." This paper offers direct experimental evidence about the link between individuals' judgment errors and market equilibrium. We perform two sets of experiments: the first establishes the absence or presence of judgment errors in a cohort of individuals. In the second experiment we change the context to a market setting. We can then observe the extent to which judgment errors observed in the individual experiments are ref lected in market prices and allocations. We further vary the types of trading opportunities to test some conjectures about how judgment errors could be eliminated in markets.

Ambiguity in Asset Markets: Theory and Experiment

“…Gneezy, Kapteyn & Potters (2003) analyze the impact of myopic loss aversion on pricing, but assumes homogeneous preferences. Kluger & Wyatt (2004) study the impact of particular cognitive biases on updating and pricing in experimental markets, but does not provide a theoretical framework within which it is possible to understand the effects (if any) of heterogeneity. Chapman & Polkovnichenko (2006) study the effects of a particular class (rank-dependent expected utility) of non-expected utility preferences on asset prices and portfolio holdings, but the preferences studied do not display ambiguity aversion in the sense studied here and equilibrium prices always admit a representative agent rationalization.…”

Asset Prices and Informed Traders' Abilities: Evidence from Experimental Asset Markets

“…Experimental research suggests that such abilities differ across traders (e.g., Peterson, 1993;Ackert & Church, 2001, Kluger & Wyatt, 2002. Theoretical models have long recognized the importance of heterogeneity among agents in explaining economic behavior (e.g., Figlewski, 1978;Haltiwanger & Waldman, 1985;Chiarella & He, 2002).…”

“…We empirically examine the association between number of smart informed traders and the closing price period and determine whether the results are comparable across market sets. As Kluger & Wyatt (2002) argue, an understanding of this issue is critical to link individual and market outcomes.…”

“…Ganguly, Kagel, & Moser (1994; and Tuttle, Coller, & Burton (1997) report that individual biases persist in market pricing, whereas Knez, Smith, & Williams (1985), Forsythe, Nelson, Neumann, & Wright (1992), and Forsythe, Reitz, & Ross (1999) find otherwise. More recently, Ackert & Church (2001) and Kluger & Wyatt (2002) suggest that the mix of traders who are susceptible to judgment biases affects whether rational market outcomes are achieved.…”

On the Microstructure of Price Determination and Information Aggregation with Sequential and Asymmetric Information Arrival in an Experimental Asset Market

“…(1988) [50], Abbink and Rockenbach (2004) [1]. Institutions thought to be important for immediate market "corrections" during the bubble periods, do not do so, but other instances in which individual behavior seems at odds with orderly market development are offset by the heterogeneity of agents, Kluger and Wyatt (2004) [33], Olivin and Rietz (2004) [40]. Bubbles themselves have been shown to be closely related to confusion on the part of agents, Lei, et.…”