Investor psychology in the stock market: An empirical study of the impact of overconfidence on firm valuation

Abstract

Behavioral theories suggest that overconfident investors overestimate the quality of their information and underestimate risk. They have a high demand for risky assets and require a lower risk premium, causing asset prices to rise and leading to overvaluation. We investigate how overconfidence affects firm valuation in Saudi Arabia's emerging stock market. We used 4004 firm-quarter observations. To ensure that our results are robust to unobserved firm-specific heterogeneity and endogeneity issues, we used the fixed-effects panel data model and the dynamic panel data model. The findings show that overconfidence positively and significantly affects firm valuation. Results remain robust when using various overconfidence proxies and when replacing the different econometric models. This study has important implications for academics, investors, and regulators. Hopefully, it will make investors more aware of the impact of their psychology on asset pricing; thus, increasing the rationality of their stock market decision making for improved market efficiency.