Overconfident Traders Research Articles

The Overconfident Trading Behavior of Investors and its Non-Linear Effect on Stock Returns: Evidence from S&P500 and S&P600 Stock Markets Based on Panel Threshold Regression

The Overconfident Trading Behavior of Investors and its Non-Linear Effect on Stock Returns: Evidence from S&P500 and S&P600 Stock Markets Based on Panel Threshold Regression

Uncertainty about fundamental, pessimistic and overconfident traders: a piecewise-linear maps approach

Uncertainty about fundamental, pessimistic and overconfident traders: a piecewise-linear maps approach

Market Timing Skill and Trading Activity in Taiwan’s Retail-Dominated Futures Market

There has been substantial research on performance persistence among professional and retail investors. These studies typically employ infrequently sampled data on portfolio holdings and returns, making it difficult to distinguish skill from luck, let alone differentiate between superior security selection and market timing ability. Based on 10 years of comprehensive account-level data comprising 61 million trades made by investors in Taiwan’s retail-dominated futures market, the authors confirm that institutions consistently earn alpha at the expense of behaviorally biased individual traders. The authors introduce an approach for separating overconfident traders from skilled market timers. This novel skill measure interacts prior performance with past trading volume. Investors identified as highly skilled subsequently earn a net-of-cost average annual return of 115%. The authors’ results contribute in two ways: (1) introducing a new measure for assessing high-frequency trading skill and (2) validating the intuition that significant alpha can be harvested by active investors in retail-dominated markets. <b>TOPICS:</b>Futures and forward contracts, emerging markets, manager selection, performance measurement <b>Key Findings</b> ▪ The authors employ comprehensive data on 61 million individual trades made by investors in Taiwan’s financial futures market over a 10-year period to confirm that behaviorally biased retail investors consistently lose to institutional investors. ▪ They demonstrate weak performance persistence and a nonlinear relationship between past trading volume and future performance, characterized by overconfidence on the part of a vast majority of traders and rational learning about skill by the most active traders. ▪ The authors describe a method for inferring true market timing ability from a combination of data on prior performance and past trading volume and identify a small subset of skilled traders who subsequently earn extraordinary profits after accounting for transaction costs.

Mitigating free riding in social networks: The impact of underestimating others’ ability in financial market

This study investigates overconfident traders who underestimate their contemporaries’ information processing ability, and it examines the impact of these traders on the financial market within the framework of social networks. As a byproduct, we also explore the impact of traders who overestimate their own ability, which is another manifestation of overconfidence. We find that when information acquisition is endogenous, market outcomes are improved by the effects of both underestimation and overestimation biases. The underlying logic is that traders’ overconfidence adds friction to free-riding on contemporaries’ information, thereby mitigating the information crowding-out effect of social communication. The results are robust to the extension of endogenous network formation and varying information acquisition costs.

Concentrated Trading and the Survival of Overconfident Traders

We build a strategic trading model where the overconfident trader earns more than the rational trader and the mechanism for this result differs from that of Kyle and Wang (1997). In this paper, discretionary and nondiscretionary liquidity traders coexist. The overconfident insider is less worried by the market maker and thus induces a lower liquidity cost. In this way, he attracts all the trading from the discretionary liquidity traders, which enables the survival of the overconfident trader.

Option Market Signals and the Disposition Effect Around Equity Earnings Announcements

The authors provide evidence that equity traders who miss or ignore signals from the options market have an increased disposition to hold their loser positions following earnings announcements. Postearnings equity returns that (do not) align with pre-earnings options market signals are fast (slow) to return to ordinary levels. We attribute this to the disposition effect arising from overconfident traders. The authors furthermore show an enhanced positive relationship between postearnings equity returns and option-implied volatility spreads when those spreads are driven by deep out-of-the-money options, which we attribute to the existence of private information.

Contrarians or momentum chasers? Individual investors’ behavior when trading exchange‐traded funds

Conducting the first study of momentum impact on households’ exchange‐traded fund (ETF) trading behavior, we find that Finnish households are less contrarian when trading benchmark index ETFs than when trading common stocks. Also, their propensity to chase recent positive momentum is higher when purchasing ETFs than when purchasing stocks. As expected, results are stronger for ETF purchases than sales. Our findings are consistent with hypotheses that households are less overconfident trading index ETFs than common stocks, that contrarian behavior is more often rational when trading stocks than when trading ETFs, and that households trade ETFs for the long run.

Longshots, overconfidence and efficiency on the Iowa Electronic Market

We study the forecast accuracy and efficiency of popular “binary” prediction markets. Such markets forecast probabilities for future states of the world (e.g., election winners) by paying off $0 or $1 depending on the realized state (e.g., who actually wins). To assess accuracy, forecast probabilities must be compared to realization frequencies, not individual realizations. We use Iowa Electronic Market (IEM) data to test efficiency against two alternative propositions from behavioral finance: the longshot bias and the overconfidence bias (which yield opposing predictions). No longshot bias appears in IEM markets. Nor does overconfidence influence prices at short horizons. However, overconfident traders may bias prices at intermediate horizons. While the markets are efficient at short horizons, non-market data indicate some intermediate-horizon inefficiency. We calculate Sharpe ratios for static trading strategies and document returns for dynamic trading strategies to assess the economic content of the inefficiencies.

Overconfidence, trading volume and liquidity effect in Asia’s Giants: evidence from pre-, during- and post-global recession

In this paper, we present evidence in favour of the overconfidence bias and its persistence in pre-, during and post-global recession sub-samples in China and India. The Chinese and Indian investors follow past market returns for the longer duration and trade excessively, which is posited as overconfidence bias. The global recession is facilitated as a structural break to examine the endurance of the overconfident trading activities. The Chinese investors are found to be more overconfident than the Indian investors in each sub-sample. We also explore that the Chinese and Indian investors are more overconfident in up than in down market states and overconfident trading behaviour of the Chinese investors is more than that of the Indian investors in both market states. The endogenous structure of vector autoregression also considers liquidity as one of the drivers of overconfident trading behaviour. Besides trading volume, market liquidity also follows market returns for a short duration, but not vice versa. The lead–lag relationship of volume–volatility and liquidity–volatility is also explored by considering volatility as the exogenous variable.

Managerial Structure and Performance-Induced Trading

We propose a new channel through which teamwork improves mutual fund activity: by offsetting individual manager overconfidence, teams mitigate excessive performance-induced trading (PIT). The predictions of our theoretical model are confirmed in the data. Team-managed funds trade less after good performance than single-managed funds and this differential increases with team size. Moreover, changes from single-to team-management correspond to lower PIT. Our results cannot be explained by alternative explanations, including manager experience, fund governance, gender, and fund flows. Overconfident trading by single-managed funds results in lower next-period returns compared to team-managed funds. Our findings indicate that team-management reduces uninformed overconfident trading.

The overconfident trading behavior of individual versus institutional investors

A double-threshold GARCH model is employed to simultaneously investigate the relative degree of overconfident trading of individual versus institutional investors and the impact of their overconfident trading on stock return volatility across high and low market return regimes. The results show that both individual and institutional investors trade more overconfidently in high market return regimes than in low, which corresponds to the finding that the return volatility is also higher in high market return regimes compared to low regimes. Conditional on the market state, market volatility, and market liquidity, it is believed that both individual and institutional investors exhibit more pronounced overconfident trading behavior when the market is up, less volatile, and more liquid across market return regimes. Finally, we obtain consistent evidence that individual investors trade with more overconfidence than institutional investors in these market conditions during high market return regimes, indicating that individual investors are more overconfident traders than institutional investors.

Disposition Effect and Overconfidence in Pakistani Stock Market

In worldwide financial markets, increased trading is a more common observable factor that not goes in favor of the standard of classical economic theory based on rational agents and efficient markets. Previous research suggests that market performance operate the level of overconfidence and disposition effect because these factors shows excessive trading. We built a market-wide panel VAR model to investigate the lead-lag relationship between profitability and turnover and TSLS to check the disposition effect. Our results suggesting that investors are less overconfidence in the stock market of Karachi and disposition is also present in this stock exchange. Holding periods were longer for larger stocks and smaller for less illiquid stocks. Return of the security give effects on buy and sells level such as turnover. Hence we can say that overconfident traders mainly hold losers too long.

US and Domestic Market Gains and Asian Investors’ Overconfident Trading Behavior

We find that subsequent to both US and domestic market gains, both Asian individual and institutional investors increase their trading and that this effect is more pronounced in bull markets, in periods of relatively favorable investor sentiment, in periods of extremely high market returns, and in markets with short‐sale constraints. We also find that individual investors trade more in response to market gains than institutional investors. Moreover, we find that further integration of Asian stock markets with US stock markets after the Asian financial crisis in 1998 is an important reason for Asian investors’ response to US market gains.

Overconfidence and endogenous information acquisition

PurposeThe purpose of this paper is to examine the implications of overconfidence for information acquisition and market efficiency.Design/methodology/approachThe paper studies a model of a competitive market with both overconfident and rational traders endogenously acquiring costly differential information.FindingsThe paper shows that overconfident traders acquire more information than do rational traders, and improve market informational efficiency by making price more informative than in a fully rational market.Originality/valueThis result is in contrast with Odean where information acquisition is exogenous, and overconfidence worsens price quality. Therefore, it may be crucial to incorporate endogenous information acquisition into models of overconfidence.

Don’t Confuse Brains with a Bull Market: Attribution Bias, Market Condition, and Trading Behavior of Individual Investors

By comparing the trading behavior of individual investors in different market conditions, this paper tests the theory that attribution bias - inflated confidence in one’s own skill - creates overconfident traders. In a bull market, investors incorrectly attribute trading successes (luck) to their own abilities and therefore should be more overconfident than they are in a normal or a bear market. Consistent with this argument, we find that in a bull market investors exhibit more overconfidence indicated by the extent of excessive trading. This finding cannot be explained by alternative explanations such as disposition effect and the tendency to gamble.

Don’t Confuse Brains with a Bull Market: Attribution Bias, Market Condition, and Trading Behavior of Individual Investors

Theory predicts that attribution bias creates overconfident traders and thus causes excessive trading in the market. This paper tests this prediction by comparing the trading behavior of individual investors in different market conditions. In a bull market, investors suffer more from attribution bias and therefore should be more overconfident and trade more excessively. Using the trading records of Chinese individual investors from January 2005 to November 2008, we find that individual investors trade more excessively, measured by higher turnover and poorer performance, in a bull market than in a bear market.

Does Overconfidence Harm Individual Investors? An Empirical Analysis of the Taiwanese Market

This article uses the approaches of (Journal of Finance 53, 1998, 1775) and (The Review of Financial Studies 19, 2006, 1531) to study the influence of overconfidence on the trading behavior of investors based on the accounts of 1185 individual investors in the Taiwan market. In addition, private information, interaction effect, and credit are treated in the analysis to establish a model of psychological bias and trading behaviors. To prevent the effects of the subprime mortgage crisis on the stock market from affecting our dataset, the study period is set from January to September 2010; the data frequency is monthly so that complete economic cycles are included. Robustness analyses such as Newey–West and nonlinear regression reveal several important findings. First, Taiwanese traders exhibit the disposition effect, especially under bear market conditions. Second, on the cross-section, a more overconfident investor tends to show a higher degree of the disposition effect. Third, overconfident traders prefer to invest in small cap stocks. Fourth, leveraged, overconfident traders with private information eventually hold losers too long.

Overconfidence in Market Timing or Security Selection

Individual investors that are also natural persons play an important role in the stock market as providers of liquidity, and it is their investment performance that directly influences their rate of survival in the market. As to whether the outcome of their operating performance is due to their overconfidence, and whether this in turn influences their survival in the market, forms the basis of this study. To this end, we use data for each investor’s credit transactions in the Taiwan securities market in an attempt to verify whether the investors’ overconfident trading behavior that gives rise to wealth losses through short selling is reflected in their competence in picking stocks, as opposed to their ability to time their participation in the market as suggested by Barber and Odean (2000). We find that a threshold effect exists between the number of trade stocks of short-selling traders and their returns, that is, when the number of trade stocks is lower than the threshold value, the number of trade stocks and the return exhibits a positive relationship. However, when the number of trade stocks is higher than the specified threshold value, the relationship with the returns will be negative. However, regardless of how large the number of trade stocks is, the trade frequencies will always be positively related to the return. The results of our empirical analysis indicate that the main reason for the loss of wealth on the part of short-selling investors is their excessive number of trade stocks, and not the frequency of trades. In addition, we also find that day traders engaging in credit transactions are characterized by a significant disposition effect (i.e., a reluctance to realize losses), and investors are more inclined to be overconfident when engaging in credit transactions than when trading in common stocks.

When Overconfident Traders Meet Feedback Traders

In this paper, we develop a model in which overconfident market participants and rational speculators trade against trend-chasers. We show that the growth and the burst of a financial bubble stem from positive feedback trading. However, the presence of overconfident traders and the risk aversion of the informed speculators enhance the strength of bubbles (creation and burst). The positive feedback trading enhances the negative serial correlation of prices and the volatility of prices. We show that positive feedback traders destabilize prices more than their overconfident opponents. Generally, overconfidence increases the volatility of prices and worsens the market efficiency. But, we show that in the presence of positive feedback trading, overconfidence improves the market efficiency and dampens the excess volatility. When negative feedback traders are present most of the comparative statics are reversed. We obtain that negative feedback traders can earn positive expected profit when their number is low enough.

Who is the more overconfident trader? Individual vs. institutional investors

Guided by the Gervais and Odean (2001) overconfident trading hypothesis, we comprehensively investigate the trading behavior of individual vs. institutional investors in Taiwan in an attempt to identify who is the more overconfident trader. Conditional on the various states of the market, on market volatility, and on the risk level of the securities they trade, we find that both individual and institutional investors trade more aggressively following market gains in bull markets, in up-market states, in up-momentum market states, and in low-volatility market states and that only individual investors trade more in riskier securities following market gains. More importantly, we find that individual investors trade more aggressively following market gains in the three conditional states of the market and in high-volatility market states than institutional investors. Also, individual investors trade more in relatively riskier securities following gains than institutional investors. These findings provide evidence that individual investors are more overconfident traders than institutional investors.