Abstract
We study the impact of overconfidence on investment decisions by financial institutions. These institutions are characterized by the delegation of investment decisions to portfolio managers and the design of contracts that aim at aligning managers’ incentives with those of the institution. We show that when rational and overconfident agents acquire information of the same precision, overconfident agents trade lower quantities than rational agents. However, overconfidence also generates incentives to overinvest in information acquisition. In such cases, overconfident agents trade larger quantities and take more risk than rational agents. The direct consequence of these results is that, as far as delegated portfolio management is concerned, overconfidence generates high trading volumes only through over-acquisition of information. Based on psychological evidence that overconfidence is generated by a self-attribution bias, our results are consistent with recent empirical evidence about mutual fund managers’ portfolio-rebalancing patterns and changes in mutual funds’ advisory contracts.
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