Overconfidence Model Research Articles

A neoclassical realist model of overconfidence and the Japan–Soviet Neutrality Pact in 1941

Why did Japan conclude the Japan–Soviet Neutrality Pact in 1941, even though it knew the German-Soviet relations were deteriorating and heading towards a disastrous war? Under the Tripartite Pact, it would be irrational for Japan to approach the USSR, which Germany had decided to invade. This article examines this long-standing puzzle in Japanese diplomatic history (also an anomaly of neorealism) by developing a new neoclassical realist model termed ‘neoclassical realist model of overconfidence’ based on self-deception in evolutionary psychology using scientific realism in the philosophy of science as a metatheoretical foundation. Drawing on neoclassical realism, I argue that Japan’s balancing strategy during 1940–41, which initially reflected the tripolar structure of the international system (independent variable), ultimately resulted in the suboptimal balancing of the Japan–Soviet Neutrality Pact (dependent variable) due to Yosuke Matsuoka’s (Japanese foreign minister) self-deception, including the positive illusion and cognitive dissonance effect (intervening variable).

Information Redundancy Neglect versus Overconfidence: A Social Learning Experiment

We study social learning in a continuous action space experiment. Subjects, acting in sequence, state their beliefs about the value of a good after observing their predecessors’ statements and a private signal. We compare the behavior in the laboratory with the Perfect Bayesian Equilibrium prediction and the predictions of bounded rationality models of decision-making: the redundancy of information neglect model and the overconfidence model. The results of our experiment are in line with the predictions of the overconfidence model and at odds with the others’. (JEL C91, D12, D82, D83)

Overconfidence Mediates How Perception of past Portfolio Returns Affects Investment Behaviors

ABSTRACTInvestors’ perception of past portfolio returns predicts their investment behavior, but does this relationship mediate by overconfidence? Taking into account different aspects of overconfidence, this paper examines whether overconfidence manifested as illusion of control, miscalibration and better-than-average mediates the association between perception of past portfolio returns and investment behavior. In a survey study with individual and institutional investors from Malaysia, the results indicate that perception of higher past portfolio returns increases investors’ trading, percentage of risky share investment and the number of financial asset holding, through the mediating channel of better-than-average effect. While individual investors are influenced by this overconfidence mechanism, institutional investors are not sensitive. This finding has theoretical implication for overconfidence model, house money effect and naïve reinforcement learning. Practically, the results imply that individual investors should be careful about underlying overconfidence biases as it can lead to inefficient decisions.

Aggregate Investor Confidence in the Stock Market

ABSTRACTOverconfidence is one of the most robust findings in the field of behavioral finance, and is associated with excessive trading and risk taking among market participants. Assessment of the level of confidence of individuals in their abilities and skills is well documented. However, the literature lacks an aggregate measure of investor confidence, with this required to test its implications on a macro level. The author introduces a simple measure of aggregate investor confidence by adopting a formal model of overconfidence. The applications of the measure suggest that, in aggregate, higher trading activity occurs when investor confidence soars, particularly for smaller stocks. Subsequently, the effect partially reverses, implying a correction to an initial overreaction. 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 have a higher risk appetite when confident, as shown by increased investment in small stocks with higher risk.

Cyclical and Persistent Carry Trade Returns and Forward Premia

We show that carry trade excess returns and forward premia of exchange rates possess persistent and clear business-cycle patterns. Our results contradict the peso model of hedged carry trade developed by [Burnside, C., M. Eichenbaum, I. Kleshchelski, and S. Rebelo, 2011, Do Peso Problems Explain the Returns to the Carry Trade?, Review of Financial Studies 24(3), 853–891.] and the overconfidence model of carry trade developed by [Burnside, C., B. Han, D. Hirshleifer, and T. Y. Wang, 2011, Investor Overconfidence and the Forward Premium Puzzle, Review of Economic Studies 78(2), 523–558.]. Our results support equilibrium asset pricing models and share the habit formation view of [Verdelhan, A., 2010, A Habit-Based Explanation of the Exchange Rate Risk Premium, Journal of Finance 65(1), 123–145.] that requires countercyclical risk premia. In bad times, when risk aversion is high and domestic interest rates are low, investors require positive currency excess returns. Consistent with [Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] the cyclicality of excess returns is associated with the cyclicality of forward premia. We find that the persistence in forward premia and excess returns is related to their cyclicality. Our results are robust to the [Lustig, H., N. Roussanov, and A. Verdelhan, 2011, Common Risk Factors in Currency Market, Review of Financial Studies 24(11), 3731–3777; Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] high-minus-low (HML) and “dollar carry trade” portfolios.

The General’s Intuition

Can we trust the operational intuitions of generals? The proponents of the overconfidence model, one of the most influential perspectives in the psychology of judgment, commonly offer a skeptical answer. Generals’ operational intuitions are likely to be hampered by overconfidence and negatively affect military effectiveness. However, the successful operational outcome of General Douglas MacArthur’s decision to land at Inchon (June–September 1950) seemingly contradicts the model. We seek to complement and refine the overconfidence model by examining the Inchon landing decision through the analytical lens of the recognition-primed decision model. This model typically envisions that under specific circumstances—notably an experienced decision maker, an adequate environment regularity, and an opportunity to learn—generals are able to make quick and satisfactory decisions. We show that such a configuration was present in the Inchon landing case and helps explain both the decision process and its successful outcome.

Momentum and Market Dynamics: Are Chinese B and H Shares Different?

Research literature shows weak momentum profitability in China due to the trading behaviour of local retail investors who trade in Chinese A-shares. Therefore, we suggest momentum strategy would be profitable in non-A (B and H) shares where foreign investors play an important role instead of local retail investors. Consistent with our suggestion, we find significant momentum returns in non-A shares that are similar in magnitude to the U.S. market. Furthermore, we show that momentum returns in non-A shares are large and significant when the market continues in the same state, consistent with the overconfidence model of Daniel, Hirshleifer, and Subrahmanyam (1998).

Simultaneous versus sequential all-pay auctions: an experimental study

While both simultaneous and sequential contests are mechanisms used in practice such as crowdsourcing, job interviews and sports contests, few studies have directly compared their performance. By modeling contests as incomplete information all-pay auctions with linear costs, we analytically and experimentally show that the expected maximum effort is higher in simultaneous contests, in which contestants choose their effort levels independently and simultaneously, than in sequential contests, in which late entrants make their effort choices after observing all prior participants’ choices. Our experimental results also show that efficiency is higher in simultaneous contests than in sequential ones. Sequential contests’ efficiency drops significantly as the number of contestants increases. We also discover that when participants’ ability follows a power distribution, high ability players facing multiple opponents in simultaneous contests tend to under-exert effort, compared to theoretical predictions. We explain this observation using a simple model of overconfidence.

Multiple facets of overconfidence: Implications for driving safety

This study sought to advance understanding of overconfidence in driving, and its relationship to safety-relevant individual difference factors. We compared the traditional, general above average affect (AAE) in driving ability with an assessment of AAE in relation to compensation for impairments, such as intoxication, fatigue and distraction. General driving and driving impairment AAEs were found to be distinct with unique relationships to illusory control, driver stress, and self-reported unsafe driver behaviors (errors, violations, lapses). Illusory control was associated with driving impairment AAE but not with general driving AAE. Both AAEs were negatively related to dislike of driving but related differently to other criteria. Risk factors related to self-estimation (violations, thrill-seeking) were distinct from factors related to competence relative to peers (aggression). Men scored more highly than women did on both AAEs. Trivia and driving calibration tasks were used to discriminate three aspects of a recent Bayesian belief updating model of overconfidence: overestimation, overplacement (AAE), and overprecision. Findings indicated that overplacement in the calibration tasks was related to AAE, its conceptual equivalent. There was a significant gender difference in overplacement but no gender difference in overprecision. The unique relationships between various types and facets of overconfidence, and driving-relevant individual differences, support the need for tailoring safety interventions to drivers of differing psychological characteristics.

Aggregate Investor Confidence in the Stock Market

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.

Individual Differences in Driver Over-Confidence

This study aimed to extend understanding of individual differences in over-confidence in driver safety. First, we discriminated general driving confidence from confidence in coping with impairments such as fatigue and distraction. Second, we discriminated three aspects of overconfidence specified in terms of a recent Bayesian belief updating model of over-confidence (Moore and Healy, 2008): overestimation, overplacement and overprecision. Calibration tasks were used for this purpose. Results showed that the magnitude of overconfidence differed across the various metrics, and different metrics were only modestly intercorrelated. Confidence in handling impairment appears to be distinct from general confidence. Both forms of confidence were negatively related to dislike of driving but related differently to other aspects of driver behavior and stress. Risk factors related to self-estimation (violations, thrill-seeking) may be distinct from factors related to overplacement (aggression). Discrimination of multiple metrics for driving overconfidence may support better matching of safety interventions to the individual driver.

Overconfidence in Political Behavior

This paper studies, theoretically and empirically, the role of overconfidence in political behavior. Our model of overconfidence in beliefs predicts that overconfidence leads to ideological extremeness, increased voter turnout, and stronger partisan identification. The model also makes nuanced predictions about the patterns of ideology in society. These predictions are tested using unique data that measure the overconfidence and standard political characteristics of a nationwide sample of over 3,000 adults. Our numerous predictions find strong support in these data. In particular, we document that overconfidence is a substantively and statistically important predictor of ideological extremeness, voter turnout, and partisan identification. (JEL C83, D03, D72, D83)

Internet Search and Momentum

In a sample of Russell 3000 stocks from 2004 to 2008, we find the momentum effect (Jegadeesh and Titman (1993) and Gutierrez and Kelley (2008)) to be much stronger among those searched more in Google. Our result provides strong support for the overconfidence model as in Daniel, Hirshleifer, and Subrahmanyan (1998) for several reasons: (1) retail investors are more likely to search a stock in internet and are more likely to suffer from overconfidence and other behavioral biases; (2) investors are likely to be even more overconfident in stocks that they search and analyze on the internet; (3) as searches in Google are often led to the same information, the private signals to the investors are in fact highly correlated, thus exacerbate the impact of overconfidence. We confirm that the relation between internet search and momentum effect is not driven by other variables such as news events, size, analyst coverage, and trading volume, which have been documented to be related to the momentum effect. Finally, we find the stronger momentum effect among stocks searched more in Google mainly comes from the winners, consistent with the insight in Barber and Odean (2008) that retail investors on average purchase attention-grabbing stocks.

A Model of Overconfidence

A Model of Overconfidence

Momentum profits following bull and bear markets

This paper examines the profitability that the widely published momentum strategy achieves following bull and bear markets. Investors can gain stronger momentum profits by adopting the continuation strategy after poor lagged market returns. The longer the duration used to describe the bear state, the stronger the momentum returns that are realised. The results contradict the theoretical findings of the investors' overconfidence model of Daniel et al. (`Investor Psychology and Security Market Under- and Over-Reactions', Journal of Finance, 53, 1839-85, 1998) and the follow-the-trend model of Kim (`Long-term Momentum Hypothesis: Contrarian and Momentum Strategies', Working Paper, 2002), but concur with the theoretical results of the traders' hesitation model of Du (`Heterogeneity in Investor Confidence and Asset Market Under- and Overreaction', Working Paper, 2002).

The Dynamics of Overconfidence: Evidence from Stock Market Forecasters

As a group, market forecasters are egregiously overconfident. In conformity to the dynamic model of overconfidence of Gervais and Odean (2001), successful forecasters become more overconfident. What's more, more experienced forecasters have learned to be overconfident, and hence are more susceptible to this behavioral flaw than their less experienced peers. It is not just individuals who are affected. Markets also become more overconfident when market returns have been high.

Confidence and Investors' Reliance on Disciplined Trading Strategies

abstractResearchers and practitioners in accounting and finance often investigate or advocate particular disciplined trading strategies, but little work investigates the determinants of individual investors' trading‐strategy reliance. We report two experiments, which provide evidence that the dual‐source model of overconfidence (Sniezek and Buckley [1991]) predicts the circumstances in which investors are more likely to rely on disciplined trading strategies. Our results indicate that reliance is more likely when investors trade portfolios of securities rather than trading on a case‐by‐case basis, particularly when investors have received feedback that their previous (unaided) trading decisions have been unprofitable. These results are driven by the number of shares that investors transact rather than by investors' directional agreement with the recommendations of the trading strategy, suggesting that the effects of a portfolio approach and trading experience occur by mitigating investors' overconfidence. The effects violate an aspect of economic rationality because our experiments ensure that investors in all conditions trade the same set of securities based on the same set of information.

House Money and Overconfidence on the Trading Floor

We examine the trading activity of a population of professional futures traders for evidence of the behavioral characteristics generally referred to as overconfidence and/or gambling with the house money. The results are broadly consistent with the Gervais and Odean (2001) model of overconfidence and learning, which predicts that successful and inexperienced traders are the most likely to be overconfident. We find little evidence of overconfidence in the general trading population - a group of largely experienced traders. However, we find that the most successful traders are more likely to take risk when winning than the less successful traders - providing support for the notion that the successful are more likely to be overconfident. We also find that trader experience is related to a measure of overconfidence: traders with more experience are less likely to take more risk after a period of abnormally good profits than their less experienced counterparts.

Are Fund Managers Better in Financial Centers?

The economic literature predicts that the average skill level in any industry is higher in larger cities. The existing labor sorting mechanism may also increase overconfidence of managers in financial centers if they attribute too much of their successes to their ability rather than luck. This article examines the relation between managerial ability and behavior across cities using U.S. equity mutual fund data and the Gervais and Odean (2001) model of overconfidence. Funds in financial centers on average perform better in terms of both gross and risk-adjusted returns. These funds however exhibit under-diversification and excessive trading, which is particularly high among young funds and managers and becomes detrimental for performance for high-performing funds and following bull markets. Our results suggest that financial centers attract more sophisticated, yet overconfident money managers. JEL Classification: G14; G23