Week 5

Question 1

What is overconfidence?

Answer 1

Tendency for people to overestimate their performances, abilities, & precision of their knowledge.

Question 2

What is miscalibration?

Answer 2

• Form of overconfidence.
• Tendency for people to overestimate precision of their knowledge –> e.g. confidence intervals constructed too narrowly.

Question 3

What is the better-than-average effect?

Answer 3

• Form of overconfidence.
• Phenomenon that people tend to rate themselves as above average on certain +ve personal attributes.
• Svenson (1981) surveyed samples of students in Sweden & US –> >50% in samples rated thesemlves in top 50% for driving skills & driving safety.

Question 4

What is illusion of control?

Answer 4

• Form of overconfidence.
• Describes tendency that people overestimate their ability to control events compared to objective probabilities.
• Langer (1975) conducted an experiment in which students participated in a gambling contest, paired w either silly’ or ‘smart’-acting opponent –> subjects made significantly higher bets on their own card compared to that of ”silly” opponents –> however cards randomly assigned so does not depend on whether opponent ‘smart’/‘silly’.

Question 5

What are the 2 factors affecting overconfidence?

Answer 5

1) Demographics –> men tend to be more overconfident than women; more educated people tend to be more confident than less educated –> e.g. Bhandari & Deaves (2006) found highly-educated males more subject to overconfidence despite not being more knowledgable on investing.
2) Expertise –> people tend to be more overconfident in their fields of expertise e.g. medical professionals, investment bankers (i.e. important players in financial mkts).

Question 6

What is excess trading?

Answer 6

• Overconfidence can lead to excess trading –> investors may make trades based on mistaken beliefs about meaning or precision of info (i.e. miscalibration) –> can lead them to buy or sell securities potentially beyond what is justified by rational economic motives e.g. rebalancing or hedging needs –> can lead to increased trading volume & volatility.
• If trading volume rational, then profits earned from trading should at least exceed transaction costs.

Question 7

How does Odean (1999) provide evidence for overconfidence causing excess trading?

Answer 7

Examines trading behavior of discount brokerage customers –> finds securities investors bought did not outperform securities they sell by enough to cover trading costs & on average securities they buy underperform compared to those they sell –> suggests these investors systematically misinterpret info available to them, rather than simply misconstruing precision of info.

Question 8

How does Barber & Odean (2000) provide evidence for overconfidence causing excess trading?

Answer 8

• Suggests investor households w accounts at discount brokers exhibit better-than-average bias in stock selection & market timing, leading them to trade more frequently than is rational –> driven by miscalibration of their own knowledge & skill in investing –> consequent additional trading lead to v slight improvement in gross portfolio performance but net performance suffers –> hhs trading more frequently earn lower net annualised return compared to those trading more infrequently.

Question 9

How does Barber & Odean (2001) provide evidence for overconfidence causing excess trading?

Answer 9

• Gender used as instrument for overconfidence.
• On average, men, who are more overconfident than women, trade more than women but experience reduced net annual returns compared to women –> may be miscalibrating info as a result & hence security returns not covering transaction costs.

Question 10

How does Grinblatt & Keloharju (2009) provide evidence for overconfidence causing excess trading?

Answer 10

• Measure self-confidence (combo of competence & overconfidence) –> use regression analysis to control for competence & obtain overconfidence as residual effect.
• Overconfident investors trade more frequently & their portfolios exhibit -ve performance after transaction costs.

Question 11

How does Oberlechner & Osler (2012) provide evidence for overconfidence causing excess trading?

Answer 11

• Found currency dealers overconfident due to miscalibration based on a survey asking to give forecasts of future FX rates w 90% confidence interval –> share of intervals excluding realized exchange rate >10% in all cases (confidence interval constructed too narrowly).
• Currency dealers found to exhibit better-than-average effect due to hubris (overestimating own success) by rating themselves as above average FX traders.
• Overconfidence not driven out of FX mkt –> experienced dealers still subject to miscalibration & hubris, & are as equally overconfident as those inexperienced currency dealers, despite fact that overconfident investors should exit mkt & experience should improve accuracy of forecasts.