This First video is an introduction for behavioral finance. Also, NBR's Dan Grech is examining some psychological factors that affects investment decision and one of them is overconfidence.
This Second video is illustrating the impact of overconfident investors on the market.
Barber & Odean (2000) and Glaser & Weber (2004) performed research to investigate if the new trend of individual online trading might affect the market. One of the conclusions was that the new investing method has increased the level of trust of the investors “by providing false sense of knowledge and an illusion of control, but also by modifying the fundaments of investment decision-making” (Voicu-Dorobanţu Roxana and Marinoiu Ana Maria 2009). This citation reflects that large amounts of information leads to overconfidence and rapid and flawed decision making methods.
Also, information collected by investors is meant to be used to make predictions and make decisions based on these predictions. However since the apparition of the Internet and the amount of information offered lead to a lower precise prediction because of the level of information saturation is reached, from that point on being created just the illusion of knowledge. Thus, investors think that they are able to pick stocks better than they really do. Confirmation of the information is a real time feedback method that also increases the overconfidence level. In this process investor enter in contact subconsciously with other investors that have the same pinion and ideas about stock piking, earning predictions, and investment ideas. The investors, since the proliferation of the Internet, can virtually meet in forums for example, and they share together the same analysis and conclusions and confirm them. This process increases the confidence and can lead to bad decision-making.
Internet is clearly a key to overconfidence of the investors Data providers encourage this belief with ads such as one (from eSignal) that promises: “You’ll make more, because you know more.”
Overconfident investors can be dangerous for the stock market. Theoretical models state that the over-confidence level will make the trading frequency and the speculation level higher. Additionally, over-confident investors will have a less diversified portfolios thus a higher risk for them self and higher volatility for the market.
Before the apparition on the online brokerage, trading a stock was not done without multiple phone conversation between the client and his or her broker, who is going to give advices, and market tendencies. Currently, with the ability to trade online, trading frequency has grown exponentially and so the speculation rate. Balasubramanian, Konana and Menon (1999) list “Feeling of empowerment” as on of the basic reason for switching to on-line trading.
The relation of online trading and its relationaship with overconfidence has been the topic of many researches.
Literature review:
“Frequently, in literature, the discussion about the increase in the confidence level of the investor while online appears as an answer to the question related to the increase in trading volume. In like situations, a two-pronged approach may be encountered: the ”over-confident” investor, previously described and the „opinion differences”. The former has already been discussed, while the latter is motivated, at least at a theoretical level, by the research from 1985 and 1989 of Hal Varian. Varian generalizes the paradigm average value volatility in order to allow the use of different previous probabilities. Each investor has his own probability distribution, previously created and subjective, for the value of a risky asset. It is assumed that the values are normally distributed and have different average values. In his research, Varian (1989) has proven the fact that the trading volume is essentially determined by the differences in opinion. The net equilibrium volume for an investor depends exclusively and directly on his deviation in opinion from the average values. Harris & Raviv (1993) assume the fact that the investors starts from the same assumptions, they receive public information, which they interpret in different ways (for example, by using different actualization functions for the probabilities), hence causing differences in opinion. Kandel & Pearson (1995) model the differences in opinion as it follows: the investors receive a public signal that is the sum of two variables: the liquidity of a risky asset and a random error factor, whose average value is the difference in opinion. Morris (1995) and van den Steen (2001) have shown in their research that the differences in opinion depend on rationality. Shiller (1999), Barberis & Thaler (2003), Hong & Stein (2003), and Diether, Malloy & Scherbina (2002) consider the differences in opinion to be yet another form of over-confidence: the investors assume that their information and their valuation abilities are better that the others.”
From all the studies that has been made, the face that overconfidence of the investors is clearly related to the the apparition of new trading technologies. The multiplication of these kind of investors, might create a devastation threat for the market and thus for the economy.
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