Chapter 9: The Impact of Overconfidence on Financial Decision-making

Do people trade because of knowledge or knowledge perception?

Several related studies documented trading losses
that were perhaps attributable to overconfidence.
– 60,000 households during 1991-96 studied
– Looked at their performance (returns)
– Found that those trading the most frequently
earned an average annual return of 11.4% vs. the
market’s 17.9%
– Even net of transactions costs and adjusted for risk
those who traded the most underperformed the
market by 10% per year
– Greatest offenders were men

Overconfidence and excessive trading?

This evidence only indirectly relates trading
and overconfidence.
– How do we know that it is overconfidence that is
driving excessive trading?
• Studies from surveys and the lab try to
establish direct relationship between
overconfidence and trading activity.

Survey evidence

Another study combined naturally-occurring data
with information obtained from a survey.
• Used trading data from online brokerage accounts
and psychometric data obtained from same group of
investors who responded to an online questionnaire.
• Various measures of trading activity were correlated
with a number of metrics of overconfidence.
• Solid evidence that those who were most subject to
better-than-average effect traded the most.

Experimental evidence

In an experimental study correlation between various forms
of overconfidence and trading activity was also investigated.
• Participants first filled out questionnaires eliciting their level
of overconfidence.
• Then trading sessions were conducted:
– Subjects were endowed with cash plus stocks (with random dividends)
that they could trade
– Private signals of true dividend
– Most accurate people were given least noisy signals
• Point was to see if overconfidence and trading activity were
correlated.
• Other variables were also investigated.

Conclusions

Overconfident traders traded the most.
• And performed the worst.
• Miscalibration was predominant.
• And better-than-average effect mattered as well.
• Overconfidence mattered both at individual and
market levels.
• Other effects mattered too:
– Higher education – less trading
– Experience investing – more trading

Underdiversification and excessive risk taking

In one study underdiversification was less
severe among people who were financially
sophisticated.
• Diversification increased with income, wealth,
and age, and those who traded the most also
tended to be the least diversified.
– Perhaps because it is argued that overconfidence
is driving force behind both excessive trading and
underdiversification.

Analysts and excessive optimism

Research has established that analysts tend to be
excessively optimistic about prospects of companies
that they are following.
• True both in U.S. and internationally.
• In U.S., where tendency was most pronounced,
buys/sells were observed 52%/3% of the time.
• In Germany, where this tendency was least
pronounced, buy/sell ratio was still 39%/20%.
• Another motivation: conflict of interest and desire to
keep prospective issuers happy.