Tuesday, January 18

Why are investors so arrogant?


The big idea

Stock investors mistakenly remember their past investments as better than they actually were, leading to overconfidence in how they will perform in the future. according to our new study.

Past research has shown that investors tend to be overconfident. But there has been little explanation why. We wonder if a skewed memory could play a role.

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So we recruited about 900 investors, mostly men, that dominate the financial industry – through online forums and panels and conducted three studies.

In the first, we asked investors 401 a series of questions designed to estimate their level of overconfidence, obtain their actual performance, and determine how often they trade. To measure overconfidence, we recorded how much they expected to outperform the market over the next 12 months. We then asked them to recall, by heart, the performance of the two operations that had the greatest impact on their portfolio, positive or negative, during the previous year.

Finally, we told them to look up their financial statements and tell us how their operations actually performed.

We compared the figures they remembered with the figures they reported. We found that, on average, investors overestimated their returns from their biggest trade by 4.3 percentage points and their second biggest gain by 7.1 points. We also found that those with the most optimistic memories were the most confident and tended to trade the most frequently.

Our second study was similar to the first, except that we asked 151 investors to recall up to 10 trades that had the biggest impact on their portfolios in 2020 and then show us the financial statements. With a larger sample of trades, we were able to isolate and measure the effects of two different types of memory bias – “distortion, “When someone remembers something more positively than reality, and”selective forgetting“- to see if they could predict overconfidence.

Investors thought their trades had gained an average of 8 percentage points more than they actually did. A more detailed analysis showed that distortion played an important role in the overconfidence of the participants. And we found that investors were much more likely to selectively forget their losses than their gains.

We also found that participants with higher memory biases, that is, larger gaps between the numbers they initially recalled and the actual performance of their portfolios, tended to be more confident and to trade more frequently.

In our third and final study, we wanted to see if an intervention could reduce overconfidence, so we recruited 366 more investors and asked half of them to review the actual returns on their financial statements before measuring overconfidence. confidence. We found that those who saw their actual returns still expected to beat the market, but much less than those who had not seen their trades.

Why does it matter

Overconfident investors can not only be a danger to themselves, they can also contribute to massive market failures.

Investors brimming with confidence are more likely to incur more debt, overreact to market-related news and signals, they buy overvalued investments and make basic mistakes than their less confident peers.

This overconfidence is often a contributing factor to market bubbles and crashes, such as 2008 financial crisis. In addition to wiping out investors, the inevitable collapse of market bubbles has an impact on the economy, often leading to debt defaults, business bankruptcies and massive unemployment.

Our results suggest that biased memory probably contributes to this overconfidence.

Whats Next

We would like to push this work in two directions. We would like to conduct a field experiment to see if we can reduce overconfidence and improve returns among brokerage clients using insights from our studies. Second, we would like to further investigate the psychological processes that underlie these effects.

We also want to communicate these results more widely to the public to help investors make smarter decisions so they are better positioned to protect and grow their wealth.The conversation

Philip Fernbach, Associate Professor of Marketing, University of Colorado Boulder and Daniel walters, Assistant teacher, INSEAD

This article is republished from The conversation under a Creative Commons license. Read the Original article.


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