*4.2. Overconfidence*

The key behavioral factor and perhaps the most robust finding in the psychology of judgment needed to explain A1 or A2 or A3 is overconfidence. Overconfidence is sometimes reversed for very easy items. Overconfidence implies over-optimism about the individual's ability to succeed in his endeavors (Frank 1935). Such optimism has been found in a number of di fferent settings. Men tend to be more overconfident than woman, though the size of di fference depends on whether the task is perceived to be masculine or feminine (Hirshleifer 2001). Economists have long asked whether investors who misperceive asset returns can survive in a competitive asset market such as a stock or a currency market.

De Long et al. (1991) concluded that there is, in fact, a presumption that overconfident investors—even grossly overconfident investors—will tend to control a higher proportion of the wealth invested in securities markets as time passes. This presumption is based on the empirical observations that (a) most investors appears to be more risk-averse than log utility; and (b) idiosyncratic risk is large relative to systematic risk. Under these conditions, investors who are mistaken about the precision of their estimate of the returns expected from a particular stock will end up taking on more systematic risk. Taken as a group, these investors will exhibit faster rates of wealth accumulation than fully rational investors with risk aversion greater than given by log utility.

Kyle and Wang (1997) showed that overconfidence may strictly dominate rationality since an overconfident trader may not only generate higher expected profit and utility than his rational opponent, but also higher if he is also rational. This occurs because overconfidence acts like a commitment device in a standard Cournot duopoly. As a result, for some parameter values the Nash equilibrium of two-fund game is a Prisoner's Dilemma in which both funds hire overconfident managers. Thus, overconfidence can persist and survive in the long run.

Daniel et al. (1998) developed a theory based on investor overconfidence and on changes in confidence resulting from biased self-attribution of investment outcomes. The theory implies that investors will overreact to private information signals and underreact to public information signals. Odean (1998b) finds that people are overconfident. His paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse market-makers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders.

Benos (1998) studied an extreme form of posterior overconfidence where some risk-neutral investors overestimate the precision of their private information. The participation of overconfident traders in the market leads to higher transaction volume, larger depth, and more volatile and more information prices. An important anomaly in finance is the magnitude of volume in the market. For example, Odean (1999) noted that the annual turnover rate of shares on the New York Stock exchange is greater than 75 percent, and the daily trading volume of foreign-exchange transactions in all currencies (including forwards, swaps, and spot transactions) is equal to about one-quarter of the total annual world trade and investment flow. Odean (1999) then presented data on individual trading behavior, suggesting that extremely high volume may be driven, in part, by overconfidence on the part of investors.

Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small-value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors (Barber and Odean 2000a).

Barber and Odean (2000b) reported their analysis, using account data from a large discount brokerage firm, of the common stock investment performance of 166 investment clubs from February 1991 through January 1997. The average club tilts its common stock investment toward high-beta, small-cap growth stocks and turns over 65 percent of its portfolio annually. The average club lags the performance of a broad-based market index and the performance of investors. Moreover, 60 percent of the clubs underperform the index.

Gervais and Odean (2001) developed a multi-period market model describing both the process by which traders learn about their ability and how a bias in this learning can create overconfident traders. A trader's expected level of overconfidence increases in the early stages of his career. Then, with more experience, he comes to better recognize his own ability. The patterns in trading volume, expected profits, price volatility, and expected prices resulting from this endogenous overconfidence are analyzed. Theoretical models predict that overconfident investors trade excessively.

Barber and Odean (2001a) tested this prediction by partitioning investors on gender. Psychological research demonstrates that, in areas such as finance, men are more overconfident than women. Thus, theory predicts that men will trade more excessively than women. They documented that men trade 45 percent more than women. Trading reduces men's net return by 2.65 percentage points a year, as opposed to 1.72 percentage points for women. People (especially males) seem to trade too aggressively, incurring higher transactions costs, without higher return. From the view that the behavior of overconfident investors is irrational, and the anomaly arises because investors are not rational, Behavioral Finance does not confront, but supports EMH. Once A1 or A2 or A3 is satisfied, the market is still e fficient.
