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Investor Overconfidence and Trading Behaviors

Posted in Individual Investing, Sentiment Indicators

How overconfident are individual investors, and how does overconfidence affect their investing practices? In his November 2011 paper entitled “Financial Overconfidence Over Time | Foresight, Hindsight, and Insight of Investors”, Christoph Merkle examines relationships between the return/risk expectations of affluent, self-directed private investors and their trading activity, diversification and risk taking. To frame the relationships, he considers three elements of overconfidence:

  1. Overplacement: “I am better informed, more experienced and more skillful in investing than average.”
  2. Overprecision: Confidence intervals for expectations are too narrow (expected volatility is too low).
  3. Overestimation: Recollected performance is higher than actual performance.

Using quarterly survey data (617 total respondents, with at least 130 in each of nine rounds) and associated investment portfolio characteristics/activity (49,372 trades) for several hundred investors having online brokerage accounts with a UK bank between June 2008 and December 2010, he finds that:

  • The average (median) number of trades per quarter per investor is 11.9 (5), with average (median) number of holdings 15.7 (12).
  • The sampled investors exhibit all three elements of overconfidence:
    • On average, they expect to beat the market by 2.9% over the next three months. On a return/risk (Sharpe ratio) basis, 49% (24%) expect to outperform (underperform) the market.
    • On average, they underestimate market and portfolio volatilities by a factor two to four (depending on comparison to implied or realized volatility).
    • They overestimate their actual portfolio returns by an average (median) 4.3% (1.7%). Those with the most inflated views of past performance tend to have the highest levels of overplacement and overestimation.
  • The elements of overconfidence affect investing as follows:
    • Overplacement relates positively to high portfolio turnover (frequent trading in high volumes).
    • Overprecision and overestimation relate negatively to portfolio diversification (number and diversity of holdings).
    • Overplacement and overprecision relate positively to risk taking (portfolio volatility and beta).
  • Both actual and perceived quarterly past performance relate positively to subsequent level of overconfidence, suggesting that overconfidence is dynamic.

In summary, evidence from surveys and portfolio activity/performance of self-directed investors in the UK indicates that overconfidence: (1) elevates trading activity and risk taking and suppresses diversification; and, (2) varies with actual and perceived past performance.

Cautions regarding findings include:

  • The surveyed investors may not be representative of advised investors or investment managers.
  • The study focuses on portfolio metrics other than outcomes.
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