Definition: People overestimate how much they actually know or how good they are.

Origination:Overconfidence arises from not knowing the limits of one’s knowledge or ability

Evidence:

Fischhoff (1977): In an experiment they gave people market reports on 12 stocks and asked them to predict whether the stocks would rise or fall in a given period

– Only 47% of predictions were correct

• Slightly less than would be expected by chance

– But mean confidence rating was 65%! (calibration studies)

Most people are not well-calibrated and demonstrate miscalibration. Systematic deviation from perfect calibration Unwarranted belief in correctness of one’s answer Evidence of overconfidence

what cause the overconfidence ?

1.Better than average effect :Svenson (1981)

82% of a group of students rank themselves among the 30 percent of drivers with the highest driving safety.

2.Illusion of control: Exaggeration of the degree to which one can control their own fate, underestimate the role of chance.

3.Optimism: Most people’s beliefs are biased in the direction of optimism. underestimate the likelihood of bad outcomes. E.g. most undergraduates believe that they are less likely than their roommates to develop cancer or to have a heart attack before the age of fifty.

4.People are overconfident in their own abilities. Driving skills and social skills are better. New business owners believe their business has a 70% chance of success, but only 30% succeed.

Factors influencing overconfidence: Keasey and Watson (1989).

1.Complexity

The hard-easy effect occurs when the degree of overconfidence increases with the difficulty of the questions.As tasks get easier, overconfidence is reduced (Lichtenstein et al., 1982)

People are overconfident with general-knowledge items of moderate or extreme difficulty

2.Feedback

Failure to learn from experience is the cause of persisting overconfidence (Russo et al, 1992).

In order to learn individuals need to get feedback about the accuracy of their answers. Timely feedback can reduce bias towards overconfidence in professionals (Russo et.al, 1992)

3.Motivation? (如何影响over confidence?)

The effect of increasing the stakes in judgment tasks has been shown to have mixed results.Monetary performance incentive.

Kruglanski and Freund (1983) found changes increased and decreased motivation!

4.Skill / Knowledge

Specialists/experts often unable to express precisely how much they do not know (Russo and Schoemaker, 1992)

Russo and Schoemaker (1992) claim that (job) relevant experience to the confidence-quiz, reduces overconfidence

Heath and Tversky (1991) report greater overconfidence found for tasks in which subjects considered they had more expertise

Implications of Overconfidence

1. Overconfident investors are more certain of their value estimates than others and for this reason trade excessively. at the level of the market, higher levels of volume after bull market. 

market level　evidence: Statman, Thorley, and Vorkink (2006): After high returns subsequent trading volume will be higher as previous investment success increases the degree of overconfidence. Kim and Nofsinger (2002) discover higher monthly turnover in stocks held by individual investors during the bull market in Japan.

Individual-Level evidence: Odean (1999) Finding: stocks individuals sell subsequently outperform the stocks they buy Implications: individual investors trade too much.

However, active trading does not lead to better performance.

1).Barber and Odean (2000) find that households that trade frequently earn much lower net annualized return than those that trade infrequently. The 20% of investors who traded the most underperformed the market by 10%! Poor performance due to costs associated with high level of trading and disposition effect.

2).Barber and Odean (2001) explore the role of gender in the context of investment decision making. Men traded 45% more than women, incurring higher trading costs.Single men trading 67% more than single women, reducing their return by 1.44% more than women.Psychologists tend to refer to this aspect of men’s behaviour as self-attribution bias.

Both individual and professional investors suffer from overconfidence,Overconfident investors overestimate the precision of their information and thereby the expected gains of trading: Montier (2006) finds that 74% of fund managers perceive themselves as above average at their jobs while only a small minority believes that they are below the average.  Analysts tend to be excessively optimistic about the prospect of the companies that they are following. It is clear that analysts are much more likely to recommend a purchase than a sale. • In the US buy/sell recommendations is 52%/3%.

2.Tendency to be under diversified.Under Diversified people are quick to overweight securities when they receive a positive signal and vice versa（受消息的影响较大）. One study which looks at 3000 individual investors find that of those who hold stocks the median number of stocks in the portfolio is only one. 

• Only about 5% held 10 stocks or more

• Another study Goetzman and Kumar (2008) find that those who have traded the most tend to be the least diversified.–People feel more competent in judging the performance of domestic stocks as compared to foreign stocks,–Individuals sensitive to price trends and influenced by home bias more likely to be less diversified.

3.Disposition effect (tendency to hold on to losers too long): Often linked to regret – Also sometimes associated with overconfidence. An overconfident trader may discount negative public information, holding on to losers and taking an excessive risk.

Limitations of Empirical Studies

1.Empirical studies using proxies of overconfidence are subject to the shortcoming that overconfidence is never directly observed.

2.There are two directions in testing the validity of theoretical models of overconfidence:

Test model assumptions

Assumptions of investors’overconfidence can be evaluated by experiments and questionnaires

Test model predictions

Predictions of the link between market outcomes and investors’ overconfidence are tested by correlation of proxies

Overconfidence: Theoretical Models

Overconfidence usually modeled as overestimation of precision of one’s information

Captures the idea that people overestimate the precision of their knowledge

Overconfident investors underestimate the variance of their private signals (contain information plus random error)

Overconfident investors underestimate the variance of the error contained in their signal

Degree of overconfidence

Stable individual trait constant over time or dynamically changes over time?

Odean (1999)

Investors receive noisy/imperfect information that they believe to be more precise than really is

Overconfidence in sense of miscalibration

Predictions include:

Increased overconfidence associated with increased trading volume

Price volatility increases with overconfidence

Overconfidence leads to excessive risk taking and lower expected utility