The Overconfidence Enemy in the Mirror

One of the questions I’m most often asked by reporters covering finance is: “What are the biggest risks facing investors?” My usual response is that the biggest risk confronting most investors is staring right back at them when they look in the mirror. And there’s plenty of academic research to support that view.

Much of that research comes from the field of behavioral finance, which is the study of human behavior and how that behavior leads to investment errors, including the mispricing of assets, thus demonstrating investors aren’t always fully rational, and that markets aren’t perfectly efficient.

Kent Daniel and David Hirshleifer, authors of the paper “Overconfident Investors, Predictable Returns, and Excessive Trading,” which was published in the fall 2015 issue of the Journal of Economic Perspectives, discuss the role of overconfidence—having mistaken valuations and believing in them too strongly—as an explanation for pricing errors, otherwise known as anomalies.

Findings

In their study, Daniel and Hirshleifer cite a wealth of literature that demonstrates:

• People tend to be overoptimistic about their life prospects, and this optimism directly affects their financial decisions.

• Overconfidence has been documented among experts and professionals, including corporate financial officers as well as professional traders and investment bankers.

• Overconfidence includes overplacement (overestimation of one’s rank in a population on some positive dimension) and overprecision (overestimation of the accuracy of one’s beliefs). An example is the overestimation of one’s ability to predict future stock market returns.

• A cognitive process that helps support overconfident beliefs is self-attribution bias, in which people credit their own talents and abilities for past successes while blaming their failures on bad luck. Self-attribution bias allows overconfidence to persist. When investors “get it right,” they upgrade their confidence in their beliefs; but when they “get it wrong,” they fail to downgrade it.

• Individual investors trade individual stocks actively, and on average, lose money by doing so. The more actively investors trade (due to overconfidence), the more they typically lose.

• The stocks that individual investors buy tend to subsequently underperform, and the stocks they sell tend to subsequently outperform.

• Actively managed funds that charge high fees without delivering correspondingly high performance provide evidence that most individual investors in active funds are overconfident about their ability to select high-performing managers.

• Men are more overconfident than women in decision domains traditionally perceived as masculine, such as financial matters. Overconfidence leads to more trading. One study found that, consistent with higher confidence on the part of men, the average turnover for accounts opened by men is about 1.5 times higher than for accounts opened by women, and as a result, men pay almost 1% per year more in higher transaction costs, and their net-of-fee returns are far lower.

• Individual investors tend to trade more after they experience high stock returns.

• Overconfidence is likely to be especially important when security markets are less liquid and when short-selling is difficult or costly (i.e., there are limits to arbitrage at work). When short-selling becomes constrained, pessimists find it harder to trade on their views than optimists, resulting in overpricing. Thus, when overconfidence is combined with constraints on short sales, we expect the security to become overpriced.

• Overconfidence plays a greater role when analysts disagree more, as measured by the dispersion in their forecasts of a firm’s future earnings. Firms with the largest dispersion of forecasted earnings tend to become overpriced, because the more pessimistic investors don’t express their views through trading. Thus, on average, these stocks earn lower returns.

• Because volatility creates a greater scope for disagreement, the overpricing of more volatile stocks is more prevalent—high-idiosyncratic-volatility stocks earn lower subsequent returns than low-volatility stocks.

Overconfidence Explains A Lot

Daniel and Hirshleifer explain: “Overconfidence provides a natural explanation for the irrational tendency for investors to be too insistent in disagreeing, and for optimists to fail to fully adjust for the fact that there are pessimists who have been sidelined by short-sale constraints. High-risk firms have greater scope for overconfidence and disagreement, so we expect this source of overpricing to be greatest for high-risk firms. In these ways, overconfidence provides a natural explanation for the idiosyncratic volatility and betting-against-beta effects” (high-beta stocks underperform low-beta stocks).

They also show how overconfidence can explain the accrual anomaly, in which stocks with high accruals tend to underperform stocks with low accruals. The authors note the well-documented tendency of people to be overconfident about fast heuristic judgments, which signals them that they don’t need to dig deeper and pay attention to details such as accruals.

Daniel and Hirshleifer conclude that “1) there are anomalies in financial markets—unprofitable active trading, and patterns of return predictability—that are puzzling from the perspective of traditional purely rational models; and 2) models of overconfidence, and of the dynamic psychological processes that underlie overconfidence, can plausibly explain why these patterns exist and persist…. Overconfidence provides a natural explanation for why investors who process the same public information end up disagreeing so much.”

As legendary comic strip character Pogo said: “We have met the enemy, and he is us.”

This commentary originally appeared May 18 on ETF.com

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