Overconfidence in investment decisions: An experimental approach

International Journal of Creative Research Thoughts, 2023

Overconfidence biases exert a significant influence on portfolio decisions, often leading investors to make suboptimal choices driven by inflated self-assessment. This study delves into the intricate interplay of cognitive and emotional mechanisms that underlie overconfidence biases and their effects on investment portfolios. Theoretical foundations are rooted in behavioral finance literature, including studies by Barber and Odean, De Bondt and Thaler, and Gervais and Odean. These biases manifest through mechanisms such as illusion of knowledge, self-perception, emotional attachment, and illusion of control, impacting decisions ranging from asset allocation to market timing. The consequences of overconfidence biases encompass excessive trading, suboptimal asset allocation, impulsive decisions, market timing errors, underestimation of risks, and loss aversion. To mitigate these effects, strategies such as diversification, passive investing, long-term planning, behavioral coaching, scenario analysis, and education have been proposed. Incorporating these strategies into investment practices can aid investors in countering the influence of overconfidence biases, making more informed and rational portfolio decisions that align with long-term financial goals. Keywords: overconfidence biases, portfolio decisions, cognitive mechanisms, emotional mechanisms, illusion of knowledge, self-perception, emotional attachment, illusion of control, mitigation strategies.

International Journal of Business and Management, 2011

The main objective of the research is to examine the excessive trading hypothesis, investors who have higher overconfidence shown by high miscalibration levels will tend to practice aggresive and excessive trading strategy. It is an experimental research which combines both between and within subject design. The participants are undergraduate students who have already taken financial management course but have not yet invest in real capital market. The result of the research shows that high overconfidence investors have higher trading activity than low overconfidence investor. The other result shows that among high overconfidence investors, there is no trading activity differences between pre and post bad news, whereas among low overconfidence investors, the existence of bad news cause trading activity to decrease in the post bad news period. Then, the investment returns of high overconfidence investors is significantly lower than that of the low overconfidence investors.

zenith

The classical theories of economics show that the individual is rational and make decisions by evaluating all information, which is available. In modern era, many economic phenomena cannot be interpreted by these theories. It is difficult for the investors to make their investment decision because they have to consider various factors before making decision. In the past, the investors had limited information to make a decision and make a decision on some information, which were easily available, but with advancements in technology, investors have to face large information heaps to make a decision. For the convenience of analysis and conclusions, scholars call such phenomena “abnormal phenomena” or “contradictory phenomena”. Behavioral finance aims at the phenomena which cannot be explained by modern corporate finance, utilizes analytical methods of psychology and adds human factor. It has been verified by experiments. In realistic society, although most investors/ managers have received theoretical training and rich experience in participating in business and management and stock market, there are still many irrational decision-making reasons. People often cannot make rational judgment due to emotional factor. Even if investors are absolutely rational, they cannot own all reliable information. Therefore, it is very difficult for people to effective conclude things they observe. Such real phenomenon completely deviates from the hypothesis of rational economic persons. This is also the primary cause why decision-making behaviors of investors are often irrational and thus result in decision biases. There are many psychological factors influencing decision biases, including overconfidence, herd behavior, emotional bias and preference for current situation. This study only discusses overconfidence and emotional factors in investment decisionperformance process.

Journal of Asia-Pacific Business, 2019

Investors' perception of past portfolio returns predicts their investment behavior, but does this relationship mediate by overconfidence? Taking into account different aspects of overconfidence, this paper examines whether overconfidence manifested as illusion of control, miscalibration and better-thanaverage mediates the association between perception of past portfolio returns and investment behavior. In a survey study with individual and institutional investors from Malaysia, the results indicate that perception of higher past portfolio returns increases investors' trading, percentage of risky share investment and the number of financial asset holding, through the mediating channel of better-than-average effect. While individual investors are influenced by this overconfidence mechanism, institutional investors are not sensitive. This finding has theoretical implication for overconfidence model, house money effect and naïve reinforcement learning. Practically, the results imply that individual investors should be careful about underlying overconfidence biases as it can lead to inefficient decisions.

2017

The purpose of this study is to investigate the influence of behavioral biases, overconfidence and loss aversion on the decision making behavior of individual equity investor by considering the risk perception as mediator. The results of the study are helpful for policy makers, financial advisors, equity investors, finance teachers, and finance students. The individual equity investor knows which bias is interrupting his decision making process, and who is reducing these biases and making their decision making level stronger. Data was collected through convenient sampling using questionnaires. The respondents were the investors of Islamabad stock exchange, brokerage houses and bankers. 250 questionnaires were distributed of which 160 were returned, making the response rate approximately 64% percent. The result indicated that investors are affected by overconfidence and loss aversion bias. Both biases have a significant impact.

The Journal of Socio-Economics, 2010

This paper explores systematic distortions of subjective probabilities by overconfident investors. In agreement with many non-expected utility theories, our devised setup acknowledges nonlinear weighting of physical probabilities by both rational and overconfident investors. Overconfidence -assumed to be higher after a history of gains and lower after a history of losses -changes these probability transformations. Using US asset price data, overconfident investors are found to be more optimistic than rational investors about future prospects.

2018

Some of the most disastrous events in human history are connected to overconfidence, a cognitive bias defined by a miscalibrated risk adjustment and an overestimation of one’s capability to alter any given outcome (Grubb, 2015; Johnson, 2009; Lichtenstein et al., 1977a). The two core meltdowns of the nuclear power plants in Chernobyl and Fukushima are prominent examples that have been associated with the bias (Piehlmaier, 2013; Song & Kim, 2014). Research shows that overconfidence spans across cultures, professions, and socioeconomic milieus (Fuchs et al., 1998; Oskamp, 1965; Svenson, 1981; Yates et al., 1996). Its influence is especially pronounced in situations of uncertainty and whenever direct feedback is unavailable (Arkes et al., 1987). Consequently, investors are of special interest to research on overconfidence because financial markets are characterized by risk and uncertainty. Similarly, investors have a monetary incentive to optimize their returns without being plagued by...

Applying a standard questionnaire to a sample of 44 professional investors, we sought for explicit correlations between selected biological characteristics of the investors and the cognitive bias known as overconfidence. We found that both male and female investors showed overconfidence above the subjective probability of 0.7 and underconfidence below this threshold. But the sexes seemed to behave differently when they were totally uncertain of their answers. Experienced and inexperienced investors were overconfident whenever they were 70 percent (or above) confident of their answers. Despite that, experienced investors were relatively more calibrated. Of those who were highly uncertain of their answers, the inexperienced showed less confidence. Moreover, a logistic regression analysis showed that male subjects, fathers, right-handers, and subjects with a university degree and less than five years of experience in stock markets were more prone to the overconfidence effect.

Review of Economic Studies, 2005

We measure the degree of overconfidence in judgement (in the form of miscalibration, i.e. the tendency to overestimate the precision of one's information) and self-monitoring (a form of attentiveness to social cues) of 245 participants and also observe their behaviour in an experimental financial market under asymmetric information. Miscalibrated traders, underestimating the conditional uncertainty about the asset value, are expected to be especially vulnerable to the winner's curse. High self-monitors are expected to behave strategically and achieve superior results. Our empirical results show that miscalibration reduces and self-monitoring enhances trading performance. The effect of the psychological variables is strong for men but non-existent for women.