Overreaction and Optimism

 The behavioral factors do exist and that they are, in fact, considered by the market. As a result, the purpose of this section is to review the psychological factors that play an important role in investors’ decisions. In order to focus the study, De Bondt (1998) has been used to narrow the selection of empirical anomalies to two factors: overconfidence and overreaction. De Bondt identified and reviewed four classes of anomalies regarding individual investors that have to do with:

(1) Investors’ perceptions of the stochastic process of asset prices;

(2) Investors’ perceptions of value;

(3) The management of risk and return; and

(4) Trading practices.

De Bondt illustrated these anomalies with selected results from a study of 45 individual investors in the Fox Valley in Wisconsin (USA). The investors were recruited at a conference organized by the National Association of Investment Clubs in Appleton. Every investor personally managed an equity portfolio and the mean value of their financial portfolio was $310,000 (Excluding real estate). The investors also agreed to make repeated weekly forecasts of the Dow Jones Industrial Average (DJIA) and of the share prices of one of their main equity holdings; i.e. the study tracked the group’s forecasts for the future performance of both the Dow Jones and their own stocks. The esearch took place between October 1994 and March 1995.

De Bondt’s findings showed the following:

(i) Investors were excessively optimistic about future performance of the shares they owned but not about the performance of the DJIA.

(ii) They were overconfident in that they set overly narrow confidence intervals relative to the actual variability in prices. They set their high guess too low and their low guess too high. Additionally, the confidence intervals were asymmetric. The average investor imagined more downward than upward return variability. As a result, they found themselves surprised by price changes to their stocks more frequently than they had anticipated.

(iii) Their stock price forecasts were anchored on past performance.

(iv) They rejected the notion of risk that relied on whether the price of a stock moved with or against the market (they underestimated the covariance in returns between their portfolios holdings and the market index; i.e. they underestimated beta). Additionally, they discounted diversification; i.e. holding few stocks was a better risk management tool than diversification

In short, De Bondt’s survey highlights two of the most important behavioral factors that have been affecting financial decisions over the years: overconfidence and overreaction. Specifically, the survey informs us that individual investors display excessive optimism and overconfidence, and that they overreact to both bad and good news. These anomalies can widely be seen among investors’ behavior and their impact on financial decisions is very strong. As a consequence, these anomalies constitute two of the main areas of interest that BF scholars have nowadays.

Consequently, this section focuses on the anomalies on overconfidence and overreaction, trying to

(1) Identify their main issues and propositions;

(2) review the empirical models that were used; and

(3) Develop a strength and weakness analysis, discussing if the research designs were appropriate to measure the behavioral factor and if questions have been left unanswered.

Overconfidence

1) Identification of its main issues and propositions.

Psychological studies have found that people tend to overestimate the precision of their knowledge (Lichtenstein, Fischhoff and Philips, 1982), and this can be found in many professional fields. They also found that people overestimate their ability to do well on tasks and these overestimates increase with the personal importance of the task (Frank, 1935). People are also unrealistically optimistic about future events; they expect good things to happen to them more often than to their peers (Weinstein, 1980 and Kunda, 1987). Additionally, most people see themselves as better than the average person and most individuals see themselves better than others see them (Taylor and Brown,

1988). in regards to financial markets, when people are overconfident, they set overly narrow confidence bands. They set their high guess too low and their low guess too high. There are two main implications of investor overconfidence.

The first is that investors take bad bets because they fail to realize that they are at an informal disadvantage. The second is that they trade more frequently than is prudent, which leads to excessive trading volume (Shefrin, 1998). As a result, financial markets are affected by overconfidence.

But how are markets affected by this overconfidence factor?