Tutorial 6: Overconfidence and investors (Topic 4)

1. Terms/concepts

a. Miscalibration and excessive optimism A person who suffers from miscalibration overestimates the precision of his knowledge, whereas one who suffers from excessive optimism thinks good things (e.g., succeeding in a business venture) are more likely to happen than objectively should be thought.

b. Better-than-average effect and illusion of control

• The better-than-average effect refers to the tendency for a person to rate himself as above average.
• If you are subject to illusion of control, this indicates a tendency to think that you have more control over events than can objectively be true.

c. Self-attribution bias and confirmation bias

• Self-attribution bias; the tendency to attribute successes to one's own abilities, while blaming failures on circumstances beyond one's control (forget our defeats)
• confirmation biases, tendency to search out evidence consistent with prior beliefs and ignore conflicting data
• Hindsight bias say we knew what was going to happen when we really didn't (e.g. 'I knew this would happen')

d. Pros and cons of overconfidence Research shows that predictions about the future tend to be more optimistic when the event forecasted is in the more distant future or when a person has committed to a course of action.
When these conditions are met, excessive optimism may be useful in enhancing performance.
Otherwise, it can lead to biased decision-making.

2. Is miscalibration greater for easy questions or hard questions? Is it greater when we look at 50% confidence ranges or 98% confidence ranges?* Miscalibration tends to be greater for hard questions. Sometimes one can even be underconfident in the case of easy questions. This is called the hard-easy effect. Also, miscalibration tends to be greater in the tails (98% ranges vs. 50% ranges).

3. Provide an example where someone can be both excessively optimistic and miscalibrated at the same time.

Many examples could be provided. To repeat the one from the chapter, let’s suppose you are about to bowl with your friends. In standard 10-pin bowling, 300 is the maximum score, and 200 an excellent one. You are feeling buoyant today and boldly predict 225 as your score, with a 90% confidence range of between 200 and 250. Over the year you have averaged 175, with 90% of your results falling within 50 points of this magnitude (i.e., between 125 and 225).
On the basis of your season record, you are excessively optimistic (by 50 points). Moreover, you are miscalibrated, with your confidence interval being only 50% as wide as it should be.

4. Overconfidence does not quickly dissipate via learning because of the existence of contributing biases. Explain.*

• Self-attribution bias, the tendency for people to attribute successes or good outcomes to their own abilities, while blaming failures on circumstances beyond their control, can lead to an increase in overconfidence. Suppose an overconfident individual observes personal performance outcomes that are logically a combination of external and internal (to the individual) forces. If things go well, the thinking will be that this is because of great ability, skill or knowledge (much more so than an objective consideration of circumstances would warrant), and the result will be an increase in overconfidence. On the other hand, adverse events, being only moderately ascribed to personal forces, will not lead to symmetric (but of opposite sign) revisions in overconfidence. As it were, people “learn” to be overconfident.

• Another contributing bias is hindsight bias, which pushes people into thinking that “they knew it all along.”

• Going hand in hand with hindsight bias is confirmation bias, the tendency to search out evidence consistent with one’s prior beliefs and to ignore conflicting data.

5*. In 2007 the New England Patriots (an American football team) had a banner year winning all 16 regular season games.

In these 16 games their points were: 38, 38, 38, 34, 34, 48, 49, 52, 24, 56, 31, 27, 34, 20, 28, and 38. Despite this obvious success, their fans were still a bit overconfident going into the playoffs. The consensus among fans was that they would average 50 points per game in the playoffs. Plus their fans were 95% sure that they would be within five points of this number (45 to 55). Illustrate the dimensions of their overconfidence. (For the purpose of this question, assume the Patriots participated in four playoff games.)

• score on average 36.81 points, and was believed to score at least 50 points in playoffs

  • excessive optimism

• calculate fair performance based on statistical values

• calculate the standard deviation of the distributions

• Use 95% confidence intervals

• calculate standard deviation of 18.19

Interested in the distribution of the sample mean

• standard error = 5.09,

Fair interval = [29.64, 70.36] which is broader than the estimated interval [45, 55].

• estimated interval is the subset of the fair interval
• twice as wide as the actual standard deviation of the fans

Part TWO: Impact of Overconfidence on Financial Decision-making

• Unfounded belief on ability to identify companies as potential investments; blind to any negative information
• Excessive trading; lower returns
  • keep track of each an every investment trade and then calculate the returns
• Underestimating the downside risks; surprise on underperformance
  • review investment holdings for potential poor performance
• Portfolio under diversification; taking on more risk
  • Only put 1 or two stocks in portfolio, which does not created a diversified and safe portfolio

1*. Differentiate the following terms/concepts:

a. Indirect and direct tests of relationship between overconfidence and trading activity Indirect tests are usually based on trading activity and the fact that theoretical models link overconfidence and trading activity. Direct tests are usually experimental, and they provide a direct link between overconfidence and trading activity.

b. Sensation seeking and overconfidence Overconfidence in its various manifestations has been extensively discussed in the chapter.

• Sensation-seeking on the other hand is a personality trait whose four dimensions are thrill and adventure seeking (i.e., a desire to engage in thrilling and even dangerous activities); experience seeking (i.e., the desire to have new and exciting experiences, even if illegal); disinhibition (i.e., behaviors associated with a loss of social inhibitions); and boredom susceptibility (i.e., dislike of repetition of experience).

c. Under diversification and excessive trading

• Trading is only excessive when it leads to deterioration in portfolio performance. This is when its cost exceeds its benefit.
• Under-diversification is holding too few securities in your portfolio, so that most gains from diversification are not achieved.

d. Statics and dynamics of overconfidence

• Right now most people would be judged overconfident if they were tested. This is a snapshot (or statics) issues
• The question is whether people become less or more overconfident over time

2*. Consider two investors (A and B) with the following demand curves for a stock:

REVISIT THIS

• A: p = 100 - q
• B: p = 150 – 2q

a. At a price of $50, how much will A and B purchase?

Substituting $50 into the above demand functions gives us q=50 for A and q=50 for B as well.

b. If the price falls to $30, who will increase their holdings more? Explain.

Now we redo the exercise for a price of $30. Now q=70 for A and q=60 for B. To go from 50 units, A would have to buy 20 and B would have to buy 10 units.

c. On this basis, which investor seems to be more overconfident?

In terms of overconfidence, it could be said that A is more overconfident than B.

3*. Discuss what the evidence (using naturally-occurring data, survey data, and experimental data) suggests about the relationship among overconfidence, trading activity, and portfolio performance.

Most of the evidence indicates that overconfidence leads to greater trading activity. It is appropriate to use the word “excessive” because this trading leads to poorer portfolio performance.

• The evidence is mixed on what manifestation of overconfidence (miscalibration vs. the better-than-average effect) contributes the most.

4*. What evidence is there that people do not diversify enough? Why is it that this occurs? What is the simplest way to “buy” a high level of diversification in an equity portfolio?

In one study 3,000 U.S. individual portfolios were examined. Most held no stock at all. Of those households which did hold stock (more than 600), it was found that the median number of stocks in portfolios was only one. And only about 5% of stock-holding households held 10 or more stocks. Most evidence says that to achieve a reasonable level of diversification, one has to hold more than 10 different stocks (preferably in different sectors of the economy). Thus it seems clear that many individual investors are quite underdiversified.

Some have linked underdiversification to overconfidence. Those who traded the most also tended to be the least diversified. It is arguable that this is because overconfidence is the driving force behind both excessive trading and underdiversification.

The simplest way to “buy” diversification is to buy an index product.

5*. Research indicates that stock market forecasters are also overconfident. Do they learn from their mistakes? Discuss.

In one study, the forecasts of a group of German market practitioners were examined. These individuals were asked to provide both forecasts for the future level of the DAX (the German counterpart to the Dow) and 90% confidence bounds. This respondent group was egregiously overconfident. Their dynamic behavior, however, seemed more in line with rational learning than self-attribution bias because respondents narrowed their intervals after successes as much as they widened them after failures. At the same time this research found that market experience made overconfidence worse, which is more consistent with a “learning to be overconfident” view and self-attribution. A likely reason for this is that experience is a double- edged sword.

• While we learn about our abilities (or lack thereof) from experience, those surviving in financial markets often have done so because of a run of success (good luck?) which has reinforced overconfidence through self-attribution bias.