Iscuss the effect of over-confidence on investors decision making
– Definition of Overconfidence
– Define investor: Trader and Retail Investor
– Decision making:
For traders : The trading volume (trade or no trade)or excessive trading i??Learning to be confidenti??,
For retail investors : prefer to hold 1 share instead of 10 or more (Underdiversification). We make a decision in order to have positive return
– Why and how over-confidence does it related to investorsi?? decision making
The main body:
– Number of factors lead to overconfidence (gender, culture, age(demographic), experience, knowledge and occupation)
– How does the above factor affects the overconfidence
– On the retail investor i?? bounded rationality + limited time and knowledge to analyse a full report on the portfolio, most of the retail investor does not have the time to do this research underdiversify (taking on risk which there is no apparent reward)
– On the traderi??s perspective, how does it affect decision making (the volume of trade increase significantly)
Terrance Odeon formulates model in which receive noisy signals, several predictions are derived from the model, including
1. Expected trading volume increases as volume increases
2. Price volatility increases
3. Overconfidence worsen the quality of price, less likely to be accurate estimated value
4. Lower expected utility for overconfident traders
Find evidence to show that traders contribute large amount of shares in the stock market.
Find evidence to show that when traders encounter high volatility, it is harder for them to make decision.
Picking a security is a difficult task and with the attached volatility, it is even harder. Hence, people will exhibit greater overconfidence. (Hard Easy effect) (Vicious cycle)
– Consequences for tradersi?? behaviour:
At micro level: 1. cognitive bias(because of overconfidence, highly depends on knowledge rather than statistical data leads to poor decision making, there is always a miscalibration, i.e. estimate always not equal to the actual.
2. Although traders are mostly regarded as responsive, it may have a positive effect on the gross returns, high volume of trading could have incurred high amount of transaction cost, the net return will therefore be a lot lower.
At the macro level: Overconfidence may have a relationship with speculative bubbles, as if the speculative bubble burst out, the consequence would be at Macro level, not affecting onei??s investment but also as a whole. (Example: Dot.com bubbles)
How over-confidence favours onesi?? decision making (1. When the last outcome far off expected and proceed to next course of action 2.committed to the job)
Conclusion: the pros overweighs the cons, and therefore people should not be overconfidence when making investment decisions.
Reading list : (Extremely important)
Please Use this book : Behavioral Finance by Ackert & Deaves Abbreviated (A&D)
Mostly Chapter 6 & 9, I have noted the page number of the book for each section.
There is an Ebook on Google