Abstract
Overconfidence is one of the most robust findings in the field of Behavioural Finance, and is associated with excessive trading and risk taking among market participants. Assessment of the level of confidence in their abilities and skills is well-documented for individuals. However, the literature lacks a measure of aggregate investor confidence, in order to test its implications on a macro-level. This paper introduces a simple measure of aggregate investor confidence by adapting a formal model of overconfidence. Applications of the measure suggest that, in aggregate, trading activity is high when investor confidence is high, particularly pronounced for smaller stocks. The effect partially reverses thereafter, suggesting partial correction of initial overreaction through overconfidence. The newly introduced investor confidence index possesses better ability to predict trading activity than past returns, as used in prior studies. Additionally, investors tend to increase risk appetite when confident, represented by increased investment in stocks associated with higher risk.
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