Behavioral nance suggests that trading volume and return volatility should follow a positive casual pattern in either direction. Behavioral insights were used to explain the results reported recently by Darrat et al. (2003) for the 30 DJIA stocks. The results show that higher trading volume causes higher return volatility in almost all DJIA stocks, and that the causal effects are also statistically signicant in a large number of the stocks. These ndings support overcondence hypothesis, but contradict the rational-expectations prediction of a negative causal effect from volume to volatility. On the other hand, reverse causality from volatility to volume, although positive for all stocks, fails to achieve any statistical signicance in the vast majority of the stocks. Clearly, such results cast some doubts on the validity of Andreassens (1990) salience hypothesis.

Therefore, the evidence seems to suggest that investors suffer from an overcondence psychological error, inducing them to trade too aggressively, driving prices away from their fundamental values, and triggering higher volatility. This could partly explain why market volatility appears too high to be compatible with rational behavior (Shiller, 1981), and could also explain why stock prices temporarily deviate from their fundamental values (Zhong et al., 2003). Finally, the analysis indicates that trading volume could be a useful predictor of future movements in stock prices. It does appear that it takes volume to move prices. Yet, caution should be exercised since some components of the trading volume might be due to investors heuristic-driven biased predictions rather than to genuinely new information about market fundamentals. ch06 February 18, 2008 16:13 spi-b567 Advances in Quantitative Analysis of Finance and Accounting: Vol.6

124 A. F. Darrat, S. Rahman & M. Zhong Excessive trading adds noise to the information dispersal process, which could disrupt the price-setting mechanism and provoke vicious volatility cycles.

References Andreassen, PB (1990). Judgmental extrapolation and market overreaction: On the use and disuse of news. Journal of Behavioral Decision-Making, 3, 153174. Barber, B and T Odean (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55, 773806. Barber, B and T Odean (2001). Boys will be boys: Gender, overcondence, and common stock investment. Quarterly Journal of Economics, 16, 262292. Berlyne, DE (1970). Novelty, complexity and hedonic value. Perception and Psychophysics, 8, 279286. Bessembinder, H, K Chan and PJ Seguin (1996). An empirical examination of information, differences of opinion, and trading activities. Journal of Financial Economics, 40, 105134. Blume, L, D Easley and M OHara (1994). Market statistics and technical analysis, the role of volume. Journal of Finance, 49, 153181.