Dr.
Chetan G K MDI-M
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QUESTION
Are you a good driver? Compared to the drivers you
encounter on the road, are you above average, average,
or below average?
Dr. Chetan G K MDI-M
Answer: Above average, Average or Below Average
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Dr. Chetan G K MDI-M
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TRADING STRATEGIES
BEHAVIORAL FINANCE
Overconfidence Bias: Are you as smart as you think?
Dr. Chetan G K
BEHAVIORAL FINANCE - INTRO
Behavioral finance refers to the study focusing on
explaining the influence of psychology in the decision-
making process of investors.
Dr. Chetan G K MDI-M
It describes that investors are not always rational, have
limits to their self-control, and are influenced by their
own biases.
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CONTD.
Many investors take poor investment decisions based on
emotional reactions (fear or greed).
Dr. Chetan G K MDI-M
Investors must be cautious while making investment
decisions and avoid behavioral biases to become a
successful investor/trader.
Biases create behavioral patterns that may influence
investment decision and affect financials.
Some of the behavioral tendencies may affect financial 6
well-being of the person.
Dr. Chetan G K MDI-M
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CONTD.
It uses experiments and research to demonstrate that
humans and financial markets are not always rational,
and the decisions they make are often flawed.
Dr. Chetan G K MDI-M
If you are wondering how emotions and biases drive
share prices, behavioral finance offers answers and
explanations.
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TOPIC – OVERCONFIDENCE BIAS
In one published study, 82 percent of the sampled
college students rated themselves above average in
driving ability.
Dr. Chetan G K MDI-M
Clearly, many of them are mistaken.
Many of those students were mistaken because they were
overconfident about their driving skills.
Being overconfident about driving skills might not be a
problem, but people are overconfident about their skills 9
in many things.
CONTD.
This overconfidence can even affect your financial
future.
Dr. Chetan G K MDI-M
When 2,994 new business owners (of start-ups) were
asked about their chances of success, they thought they
had a 70 percent chance of success.
Why do new business owners think they have nearly
twice the chance of success as others?
Because they are overconfident. 10
CONTD.
Interestingly, people are more overconfident when they
feel they have control over the outcome—even when this
is clearly not the case.
Dr. Chetan G K MDI-M
For example: Tossing of Coin
Peopleact as if their involvement will somehow affect the
outcome of the toss.
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Dr. Chetan G K MDI-M
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ONE MORE
RULES
Answer the questions displayed in the next slide.
Dr. Chetan G K MDI-M
If you have no idea of the answer to a question, then
your range should be wide for you to be 90 percent
confident.
On the other hand, if you think you can give a good
educated guess, then you can choose a smaller range to
be 90 percent confident.
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Dr. Chetan G K MDI-M
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DO YOU WANT TO KNOW THE
ANSWERS?
Dr. Chetan G K MDI-M
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ANSWERS
They are
(1) 250,000 pounds; (2) 1513; (3) 193 countries; (4)
Dr. Chetan G K MDI-M
10,543 miles; (5) 206 bones; (6) 8.3 million; (7) 164
million items; (8) 4,000 miles; (9) 1,044 miles per hour;
and (10) 20,000.
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EVALUATION
Most people miss five or more questions.
Dr. Chetan G K MDI-M
However, if you are 90 percent sure of your range, then
you should have missed only one!
The fact is that you are too certain about your answers,
even when you have no information or knowledge about
the topic.
This demonstration illustrates that people have difficulty
evaluating the precision of their knowledge and 17
information.
INVESTING
These perception occurs in investing as well.
Dr. Chetan G K MDI-M
Even without information, people believe the stocks they
own will perform better than stocks they do not own.
Gallup & Paine Webber survey of individual investors
conducted in early 2001 demonstrates this
overconfidence.
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CONTD.
When asked what they thought the stock market return
would be during the next 12 months, the average answer
was 10.3 percent.
Dr. Chetan G K MDI-M
When asked what return they expected to earn on their
portfolios, the average response was 11.7 percent.
Typically, investors expect to earn an above-average
return.
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CONTD.
People can be overconfident. Psychologists have
determined that overconfidence causes people to
overestimate their knowledge, underestimate risks, and
Dr. Chetan G K MDI-M
exaggerate their ability to control events.
Does overconfidence occur in investment decision making?
Yes
Security selection is a difficult task.
It is precisely in this type of task, people exhibit the 20
greatest degree of overconfidence.
OVERCONFIDENCE AFFECTS THE
INVESTOR’S DECISION
Overconfidence causes us to misinterpret the accuracy of
our information and overestimate our skill in analyzing
it.
Dr. Chetan G K MDI-M
It occurs after we experience some success.
After some success in the market, investors may exhibit
overconfident behavior.
Eg1: IPO
Eg2: Consider the behavior of financial analysts. 21
CONTD.
Overconfidence can lead investors to poor trading decisions,
which often manifest themselves as excessive trading, risk
taking, portfolio losses.
Dr. Chetan G K MDI-M
Their overconfidence increases the amount they trade because
it causes them to be too certain about their opinions.
Investors’ opinions comes from their beliefs regarding the
accuracy of the information they have obtained and their
ability to interpret it.
Overconfident investors believe more strongly in their own 22
valuation of a stock and less about the beliefs of others.
CONTD.
Psychologists have found that men are more
overconfident than women in managing finances.
Dr. Chetan G K MDI-M
Male investors trade more frequently than female do.
Brad Barber and Terrance Odean, examined the trading
behavior of nearly 38,000 households of a large discount
brokerage firm between 1991 and 1997.
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CONTD.
The study shows that single men trade the most.
Dr. Chetan G K MDI-M
Note that this is consistent with over confidence; that is,
male investors are more overconfident than female
investors, leading to higher levels of trading.
It has been observed that overconfidence leads to trading
too frequently as well as to purchasing the wrong stocks.
One criticism of the Barber and Odean studies is that
they essentially assume that high-volume traders are 24
overconfident.
CONTD.
After the overall stock market increases, many investors may
attribute their success to their own skill and become
overconfident.
Dr. Chetan G K MDI-M
This will lead to greater trading by a large group of investors
and may impact overall trading volume on the stock
exchanges.
Examining monthly stock market returns and trading volume
over 40 years shows that higher volume does follow months
with high returns.
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Alternatively, overall trading is lower after market declines.
CONTD.
Investors appear to attribute the success of a good month
to their own skill and begin trading more.
Dr. Chetan G K MDI-M
Poor performance makes them less confident and is
followed by lower trading activity.
This may be why the old Wall Street adage warns
investors not to confuse brains with a bull market!
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Dr. Chetan G K MDI-M
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QUESTION
In 1928, Dow Jones Industrial Average (DJIA) began
and it expanded to 30 stocks. In 1929, the index started
at 300.
Dr. Chetan G K MDI-M
At the end of 2016, the DJIA was at 19,787. The DJIA is
a price-weighted average.
Dividends are omitted from the index.
What would the DJIA average have been at the end of
2016 if the dividends were reinvested each year? 28
ANSWER?
What are your DJIA minimum and maximum guesses?
Dr. Chetan G K MDI-M
Again, you should be 90 percent sure that the correct
value lies within the range you choose.
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SEE THIS
This example also illustrates another aspect of investor
psychology called anchoring.
Dr. Chetan G K MDI-M
When you read the question, you focused on the DJIA price
level of 19,787.
That is, you anchored your thinking to 19,787. You probably
made your guess by starting at this anchor and then trying to
add an appropriate amount to compensate for the dividends.
Investors anchor on their stock purchase price and the recent
highest stock price. 30
ANSWER
If dividends were reinvested in the DJIA, the average
would have been 613,514 at the end of 2016.
Dr. Chetan G K MDI-M
The average annual return of 300 growing to 613,514
over 88 years is 9.05 %.
Does a nearly 9 percent average return in the stock
market seem un-reasonable?
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OVERCONFIDENCE AND RISK
Overconfidence also affects investors’ risk-taking
behavior.
Dr. Chetan G K MDI-M
Rational investors try to maximize returns while
minimizing the amount of risk taken.
However, overconfident investors misinterpret the level
of risk they take.
If an investor is confident that the stocks picked will
have a high return, then where is the risk? 32
CONTD.
The portfolios of overconfident investors will have
higher risk for two reasons.
Dr. Chetan G K MDI-M
First is the tendency to purchase higher-risk stocks.
Higher-risk stocks are generally from smaller, newer
companies.
The second reason is a tendency to under diversify their
portfolios.
Prevalent risk can be measured in several ways: portfolio 33
volatility, beta, and the size of the firms in the portfolio.
CONTD.
Portfolio volatility measures the degree of ups and
downs the portfolio experiences.
Dr. Chetan G K MDI-M
High-volatility portfolios exhibit dramatic swings in
price and are indicative of under diversification.
The series of studies by Barber and Odean show that
overconfident investors take more risks.
They found that single men have the highest-risk 34
portfolios followed by married men, married women,
and single women.
ILLUSION OF KNOWLEDGE
Where does overconfidence come from? It comes
partially from the illusion of knowledge.
Dr. Chetan G K MDI-M
This refers to the tendency for people to believe that the
accuracy of their forecasts increases with more
information;
that is, more information increases one’s knowledge
about something and improves one’s decisions.
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EXAMPLE
Rolling of a Die.
Dr. Chetan G K MDI-M
If I roll a fair, six-sided die, what number do you think
will come up, and how sure are you that you are right?
Now let me tell you that the last three rolls of the die
have each produced the number 4. I will roll the die
again.
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CONTD.
What number do you think will come up, and what is
your chance of being right?
Dr. Chetan G K MDI-M
If the die is truly fair, then you could still pick any
number between 1 and 6 and have a one-sixth chance of
being correct.
The added information does not increase your ability to
forecast the roll of the die.
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CONTD.
However, many people believe the number 4 has a
greater chance (more than one-sixth) of being rolled
again.
Dr. Chetan G K MDI-M
Others believe the number 4 has a lower chance of being
rolled again. These people think their chance of being
right is higher than reality.
That is, the new information makes people more
confident of their predictions even though their chances
for being correct do not change.
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CONTD.
Valuable information may improve prediction accuracy,
it may increase confidence at a faster rate than accuracy.
Dr. Chetan G K MDI-M
In other words, receiving more and better information
causes one’s confidence in making predictions to jump
quickly while that information only marginally improves
accuracy, if at all.
A series of experiments trying to predict college cricket
game outcomes illustrates this effect.
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Dr. Chetan G K MDI-M
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HOW TO OVERCOME THE OVERCONFIDENCE
BIAS IN YOUR INVESTMENT DECISION?
Be aware that you tend to feel more certain about an investment
future than it is.
Dr. Chetan G K MDI-M
This means you tend to take more risks than you think you are
taking. Investors should always add an extra margin of safety in
their decisions. This margin can be called the overconfidence
margin.
Be just the spectators of predictions, especially from the market
experts. Do not follow them blindly.
If you look at the forecast's history, it's amazing how wrong
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most of them were. Think and forecast for yourself and then
adjust your confidence.
CONTD.
With all plans, favor the pessimistic scenario that gives
you a chance of judging a situation realistically to some
extent.
Dr. Chetan G K MDI-M
Read history. Stock market history, economic history,
plain old political history. Even better, read a 25-year-old
newspaper.
Read the market comments in the business section. You
will see that the world is highly unpredictable. Almost
nobody got it right. Don't think that you will be an
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exception!
REFERENCES
Brad Barber and Terrance Odean, “Online Investors: Do the
Slow Die First?” Review of Financial Studies 15 (2002): 455–
487.
Dr. Chetan G K MDI-M
Brad Barber and Terrance Odean, “The Internet and the
Investor,” Journal of Economic Perspectives 15 (2001): 41–
54.
Simon Gervais and Terrance Odean, “Learning to Be
Overconfident,” Review of Financial Studies 14 (2001): 1–27.
See also Kent Daniel, David Hirshleifer, and Avanidhar
Subrahmanyam, “Overconfidence, Arbitrage, and Equilibrium
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Asset Pricing,” Journal of Finance 56 (2001): 921–965.
REFERENCES
Gilles Hilary and Lior Menzly, “Does Past Success Lead
Analysts to Become Overconfident?” Management Science 52
(2006): 489–500.
Dr. Chetan G K MDI-M
Brad Barber and Terrance Odean, “The Courage of Misguided
Convictions,” Financial Analysts Journal 55
(November/December 1999): 41–55.
Sylvia Beyer and Edward Bowden, “Gender Differences in
Self-Perceptions: Convergent Evidence From Three Measures
of Accuracy and Bias,” Journal of Personality and Social
Psychology 59 (1997): 960–970. See also Melvin Prince,
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“Women, Men, and Money Styles,” Journal of Economic
Psychology 14 (1993): 175–182.
REFERENCES
Brad Barber and Terrance Odean, “Boys Will Be Boys:
Gender, Overconfidence, and Common Stock Investment,”
Quarterly Journal of Economics 116 (2001): 261–292.
Dr. Chetan G K MDI-M
Brad Barber and Terrance Odean, “Trading Is Hazardous to
Your Wealth: The Common Stock Investment Performance
of Individual Investors,” Journal of Finance 55 (2000):
773–806.
James Choi, David Laibson, and Andrew Metrick, “How
Does the Internet Increase Trading? Evidence From Investor
Behavior in 401(k) Plans,” Journal of Financial Economics 45
64 (2002): 397–421.
Dr. Chetan G K MDI-M
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