Overconfidence 1 Confidence vs overconfidence Confidence is all

Overconfidence 1

Confidence vs. overconfidence • Confidence is all about having a positive feeling about your skills, knowledge, etc. • But overconfidence is when you have an inflated sense of your abilities. • Various manifestations: – – Miscalibration Excessive optimism Better-than-average effect Illusion of control 2

Calibration-based overconfidence • Miscalibration normally implies thinking that your knowledge is more accurate than it really is. • Measured through calibration tests. • Ask people 50 multiple choice questions. – Then ask how many right? And compare the two numbers – If you think you got 25 right…but you only got 15 right – You appear to be overconfident 3

Calibration-based overconfidence cont. • Or use confidence interval approach. • Suppose individuals are asked to construct 90% confidence intervals (e. g. , height of Mount Everest). • A percentage of individuals usually less than 90% usually comes up with intervals that bracket true answer. • This also suggests miscalibration-based overconfidence. 4

Better-than-average effect • Better-than-average effect says that many of us feel we are smarter or more skilled than average. • But only 50% of us can really be better than average. • Evidence suggests that people pick definition of task that suits their purpose. 5

Illusion of control • Reveals itself when people think that they have more control over events than objectively can be true. – For example, gamblers may think that they can control the dice or the cards 6

Excessive optimism • Present when people’s predictions about the future are unrealistically optimistic. • In essence, people assign probabilities to favourable/unfavorable outcomes that are just too high/low given historical experience or reasoned analysis. • Excessive optimism and miscalibration can go hand in hand. – Suppose you purchase a stock – True distribution for the return on this stock over the next year entails an expected return of 10%, with a 90% confidence range of -10% to 30% – You (optimistic) distribution, has expectation of 20%, with a 90% confidence range of 10% to 30% 7

Excessive optimism cont. • Evidence on excessive optimism: – Students expect to receive higher marks than they actually do receive – And they overestimate the number of job offers that they will receive – People often think that they can accomplish more than they actually end of accomplishing • Cost of excessive optimism: – Inability to meet one’s goals can lead to disappointment, loss of self-esteem and reduced social regard – And time and money can be wasted pursuing goals that are unrealistic 8

Problems measuring overconfidence • Most people most of the time appear to be overconfident. • But overconfidence does not seem to be universal. – Underconfidence is common on easy tasks • Also, depending on the metric, it is possible for people to be judged overconfident using one metric but not using another. – And there is no universally accepted way to measure overconfidence 9

Overconfidence and demographics • We are not all equally overconfident. • The greatest offenders are men: – On a survey men and women were asked what they expected the market return and their own portfolio return to be in the following 12 months. • Both men and women expected their portfolios to outperform the market – but gap greater for men • Also evidence that highly educated, highincome people are more overconfident. 10

Why don’t we learn? • Self-attribution bias retards the learning process by allowing us to embellish our triumphs while forgetting our defeats. • Hindsight bias the common tendency for people to perceive events that have already occurred as having been more predictable than they actually were before the events took place. • Confirmation bias may contribute too – this is tendency to search out evidence consistent with one’s prior beliefs and to ignore conflicting data. • These effects suggest that overconfidence can evolve over time. 11

Overconfidence may not be all bad • Research has shown that predictions about the future tend to be more optimistic when: – Goals are far off – A course of action has been committed to • When these conditions are met, excessive optimism may be useful in enhancing performance. 12

The Impact of Overconfidence on Financial Decision-making 13

Overconfidence and excessive trading • Theoretical models indicate a relationship between overconfidence and extent of trading. • To get a flavor, consider 3 investors: – High-OC investor – Low-OC investor – No-OC investor (accepts whatever the market tells him) 14

Overconfidence, excessive trading and demand curves 15

Interpretation • Difference between 3 investors: they respond differently to prices which are different from their value estimates. • Inv. 1 slavishly maintains his holding regardless of price changes: this investor wishes to hold qn at any price. • Other two investors have negatively-sloped demand curves, implying willingness to “march to beat of a different drummer. ” • Inv. 2/3 pays some/most attention to own opinion. 16

Interpretation cont. • Consider what happens as the price changes: – Higher OC leads to more trading for a given value vs. price gap • The more overconfident is the market the greater will be volume at level of market. 17

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 gross and net of transaction cost returns – Found that those trading the most frequently earned an average annual return of 11. 4% vs. the market’s 17. 9% – Greatest offenders were men 18

Gross vs. net returns Source: Barber, B. , and T. Odean, 2000, "Trading is hazardous to your wealth: The common stock investment performance of individual investors, " Journal of Finance 55, 773 -806. 19

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. 20

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. 21

Conclusions Overconfident traders traded the most. And performed the worst (not shown in table). Miscalibration was predominant. And better-than-average effect mattered as well. Overconfidence mattered both at individual and market levels (not shown in table). • Other effects mattered too: • • • – Higher education – less trading – Experience investing – more trading 22

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 23

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. 24

International evidence Source: Jegadeesh, N. , and W. Kim, 2006, “Value of analyst recommendations: International evidence, ” Journal of Financial Markets 9, 274 -309. 25