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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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