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BEHAVIORAL FINANCE

Instructor
Dr. Nabeel Safdar
OVERCONFIDENCE
 Confidence can be described as the “belief in oneself
and one’s abilities with full conviction” while
“overconfidence can be taken one step further in which
overconfidence talks this self – reliant behavior to an
extreme” (Ricciardi and Simon, 2000).
 As a human being people have tendency to
overestimate their skills and predictions for success.
 Extensive evidence shows that people are overconfident
in their judgments.
 Psychologist has found that people tend to be
overconfident and hence overestimate the accuracy of
their forecasts.
OVERCONFIDENCE
 Overconfidence is the tendency for people to
overestimate their knowledge, abilities, and the
precision of their information, or to be overly
sanguine of the future and their ability to
control it.
OVERCONFIDENCE
 Overconfidence leads to higher trading in financial markets.
 Overconfidence will result in:
 Mistaking luck for skill
 Too much risk
 Too much trading
 So people tend to overestimate their belief and ability.
 Overconfidence suggests that investors overestimate their ability to
predict market events, and because of this they often take risk
without actually receiving proportionate returns.
 Psychological studies show that, although people differ in their
degrees of overconfidence, almost everyone displays it to some
degree.
 For example most of people rate themselves as above average drivers,
but by definition 50% 0f driver are below average.
INVESTMENT MISTAKES
 Overconfident investors overestimate their ability to evaluate a company as
a potential investment. As a result, they can become blind to any negative
information that might normally indicate a warning sign that either a stock
purchase should not take place or a stock that was already purchased
should be sold.
 Overconfident investors can trade excessively as a result of believing that
they possess special knowledge that others don’t have. Excessive trading
behavior has proven to lead to poor returns over time.
 Because they either don’t know, don’t understand, or don’t heed historical
investment performance statistics, overconfident investors can
underestimate their downside risks. As a result, they can unexpectedly
suffer poor portfolio performance.
 Overconfident investors hold underdiversified portfolios, thereby taking on
more risk without a commensurate change in risk tolerance. Often,
overconfident investors don’t even know that they are accepting more risk
than they would normally tolerate.
OVER-CONFIDENCE AND OVER-TRADING
 A study was carried out utilizing trading activity of 60,000
individual investors over a six year period. The results included
the following observations:
 Individual investors weight their portfolios towards small-cap
“value”stocks (which tend to have higher risk and higher average
returns)
 Prior to trading costs, individuals beat the value-weighted market
index by 60 basis points (0.6%) –but trading costs ate up 240bp
(2.4%) of returns
 Individuals tend to be under-diversified in their portfolios
 Investors who traded most often lost the most money
 Men traded 45% more than women, chose higher risk stocks, and
earned less
 Over-confidence appears to be more evident among:
 Men rather than women
 Younger rather than older people (most on-line traders during the
internet boom were between 25-45)
OVER-CONFIDENCE AND SELF-ATTRIBUTION
BIAS
 Individuals tend to ascribe their successes to their own talents,
but their failures to bad luck
 News that confirms the investor’s own views is given considerable
attention
 News that tends to disconfirm the investor’s views is discounted
 Outcome: short-term market momentum as investors over-react to
news that confirms their initial bias, and under-react to
disconfirming information
 Self-attribution bias tends to generate increased over-confidence,
as individuals give greater weight to outcomes that support their
original hypothesis
 Self-fulfilling prophecy: if everyone believes that the market will go
up, it will in fact go up, perpetuating investor over-confidence
 Overconfidence increases over time as a function of past
investment success
OVER-CONFIDENCE AND CORPORATE
FINANCE
 Over-confident executives underestimate the time and
uncertainty with respect to a new project. This is known as the
Planning Fallacy.
 This is costly for two reasons:
 The longer the time to completion, the greater the variable costs
(e.g., labor, administration)
 The longer the wait for positive cash flows, the lower the true Net
Present Value, because profits from the delayed project will start
later than originally projected
 These problems may be exacerbated by:
 Commitment escalation: misplaced persistence with a project
because to cancel it means admitting to a mistake
 Sunk cost bias: continuing with a project despite its negative
expected value, because of the amount of money that has already
been spent
OVER-CONFIDENCE AND CORPORATE
FINANCE
 Corporate executives also tend to over-estimate overall
market returns, and also their expertise in predicting
such returns. This is known as Illusion of Control
 A business school recently carried out surveys of several
hundred CFOs over a six year time period. They asked the
CFOs to provide estimates of that year’s market return with
80% confidence intervals*
 Actual market returns were within the CFOs’80% confidence
range only 38% of the time
 Overconfident CFOs will tend to:
 Use lower discount rates to discount cash flows
 Invest more often in projects
 Use more debt (especially long term debt)
 The CFOs were asked to provide a range of
possible US equity market returns for the year,
such that they were 80% certain that the return
would be within their range. The CFOs typically
set their range too tight: 11% -18%, for
example. If the actual market return were 10%,
this would be outside the CFO’s “confidence
interval” –thus he would be wrong.
ARE WOMEN LESS OVER-CONFIDENT THAN
MEN?
 Recent research* suggests that female executives
tend to be less over-confident than men, as
evidenced by:
 Male executives undertake more corporate acquisitions
 Male executives typically issue more debt
 Female executives place wider bounds on their
earnings estimates (remember the “narrow range”
problem on the previous slide)

*Huang & Kisgen2013, “Gender and corporate finance: Are male executives overconfident relative to
female executives?” Journal of Financial Economics
EXERCISE
 Question : How easy do you think it was to predict the collapse of the
tech stock bubble in March of 2000?
a. Easy.
b. Somewhat easy.
c. Somewhat difficult.
d. Difficult.
 Question : From 1926 through 2004, the compound annual return for
equities was 10.4 percent. In any given year, what returns do you
expect on your equity investments to produce?
a. Below 10.4 percent.
b. About 10.4 percent.
c. Above 10.4 percent.
d. Well above 10.4 percent.
EXERCISE
 Question : Relative to other drivers on the road, how good a driver
are you?
a. Below average.
b. Average.
c. Above average.
d. Well above average.
 Question : Which Australian city has more inhabitants—Sydney or
Melbourne? How confident are you that your answer is correct?
Choose one:
50 percent,
60 percent,
70 percent,
80 percent,
90 percent,
100 percent.
MISCALIBRATION
 Miscalibration is the tendency for people to
overestimate the precision of their knowledge.

 Calibration Test

 Other overconfidence type is


 Better-than-average effect
 Illusion of Control
 Planning Fallacy.
SIMPLE GAME

 Quickly look at the following product of eight


numbers:

1×2×3×4×5×6×7×8
SIMPLE GAME

 Quickly look at the following product of eight


numbers:

8×7×6×5×4×3×2×1
ANCHORING

 In many situations, people make estimates by


starting from an initial value and adjusting it to
generate a final estimate. Often the adjustment
is insufficient. The initial value often naturally
comes from the frame of the problem.