Exploring market overreaction, investors’ sentiments and investment decisions in an emerging stock market

Abstract

The representative heuristic and overconfidence are cognitive biases that influence the decisions of the investors in the stock market. Overconfident investors tend to rely on representative heuristic for decision making under uncertainty. Investors overestimate their knowledge and think that past performance is the best indicator to measure the future performance of a company. Investors who are overconfident and use representative heuristics overreact to any new information that arrives in the market, and it affects their decisions. To measure the presence of overconfidence and representative heuristic in decisions making of investors trading at Pakistan Stock Exchange (PSX), we have used primary as well as stock market secondary data. Primary data was collected from 446 retail investors, and secondary data was collected from 301 companies listed in 35 sectors of PSX. We have found a significant effect of overconfidence and representative heuristic on the decision making of investors and the trade volume of the stock market. This paper adds to the literature of behavioral finance concerning the role of overconfidence as a mediator between representative heuristic and investment decisions. The evidence documented in this paper is first known to measure the role of mediator between representative heuristic and investment decisions.