Abstract
We document a memory-based mechanism associated with investor overconfidence. In Studies 1 and 2, investors were asked to recall their most important trades in the recent past and then reported investing confidence and trading frequency. After the study, they looked up and reported the actual returns of these trades. In both studies, investors were biased to recall returns as higher than achieved, and larger memory biases were associated with greater overconfidence and trading frequency. The design of Study 2 allowed us to separately investigate the effects of two types of memory biases: distortion and selective forgetting. Both types of bias were present and were independently associated with overconfidence and trading frequency. Study 3 was an incentive-compatible experiment in which overconfidence and trading frequency were reduced when participants looked up previous consequential trades compared to when they reported them from memory.
Highlights
We document a memory-based mechanism associated with investor overconfidence
We propose that overconfidence can be driven by positivity biases in memory for past performance
We tested for memory bias by comparing the actual return and the return reported from memory of the two investments separately
Summary
In Studies 1 and 2, investors were asked to recall their most important trades in the recent past and reported investing confidence and trading frequency. They looked up and reported the actual returns of these trades In both studies, investors were biased to recall returns as higher than achieved, and larger memory biases were associated with greater overconfidence and trading frequency. The design of Study 2 allowed us to separately investigate the effects of two types of memory biases: distortion and selective forgetting Both types of bias were present and were independently associated with overconfidence and trading frequency. One possible explanation for investor overconfidence is that investors are biased to recall their trading performance as better than achieved This possibility has been suspected by practitioners for some time. Distortion was found among college students who remembered their high school grades as being higher than they achieved in reality [24, 25] and among patients who recalled their cholesterol scores and cardiovascular risk categories as more favorable than shown on a recently viewed test [26]
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