Economics Journal Rewrite
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Abstract
The behaviour of investors in the financial markets has shifted drastically over the previous decades from investors making rational decisions because of psychological biases. The paper shows two factors that have led to the drastic shift in security markets: substantive evidence that shows how investors’ behaviour has been influenced by psychological bias; and accumulation of evidence that illustrates the rational response does not guide the rate of security market exchange quantities and returns. The assets market has registered high trading volumes because investors have been attracted to excessively trading assets that portray high risks and net returns that are relatively low. Moreover, the prices of assets in the markets depict predictability patterns that are rarely associated with the various rational expectations based theories of forming prices. The paper majorly focuses on outlining the significance of overconfidence in explaining the high trading volumes and predictability of assets prices in the security market.
Keywords: overconfidence, psychological bias, investors, security markets.
Economics Journal Rewrite
Kent, D. & Hirshleifer, D. (2015). “Overconfident Investors, Predictable Returns, and Excessive Trading.” Journal of Economic Perspectives, 29(4): 61-88. https://doi.org/10.1257/jep.29.4.61
Market efficiency theory suggests that prices of securities must portray the information available in the public where investors compete with one another in financial markets that do not have transaction costs. In this theory, all investors should make rational decisions and information of the securities should be readily available. Following these assumptions, investors should possess their unique market portfolio after analyzing the financial markets. The rapid increase in the volumes being traded in the financial markets shows that this theory is not being applied. The high trading volumes suggests that investors can predict their levels of returns. This leads to investors allocating huge sums of money on overpriced assets that generate low net profits hence missing the opportunity to gain high yields on underpriced securities. The excessive volumes can also be explained by the fact that investors assume that high risky assets generate more returns than low risky assets.
Several economists associated the large volumes of securities traded in financial markets to the simultaneous rise in demand and decrease in the supply of assets. This received various criticisms because it could not explain the excessive trading and the investors’ willingness to pay the huge transactions costs involved in making such risky trades. In 2014, $ 29.5 trillion was traded in the top 500 stocks, which exceeded the GDP of the US. The research is done on the relationship between overconfidence and vast trade volumes clearly explained the investors’ behaviours. Overconfident investors rely on their ability to judge the pricings of several assets using analysis made by other investors. This leads to overconfident investors allocating a lot of money and expecting enormous returns based on other investors analysis. This is commonly referred to as actively investing puzzle, which makes individuals trade more frequently hence losing more money.
Actively investing puzzle is experienced at different levels according to investors. Men actively spend more than women because men are overconfident in financial matters. Accounts opened by men experience a turnover that is 1.5 times more compared to women accounts. Consequently, men pay more transaction costs in a year. Another example of active investing is that investors who have experienced high stock profits tend to trade more. As a result, investors excessively rely on their ability to predict the returns of future assets. Self- attribution argues that people relate their success to their talents and skills while they fail to acknowledge their failures by blaming it on bad luck. Overconfident investors often apply this cognitive process hence making reckless decisions. Overconfidence among investors is experienced more when assets markets are less liquid, and when investors rarely sell stocks because they predict that their prices will fall. This makes optimist overvalue the stocks which disrupt the equilibrium of pricing. The drawback caused by overconfidence in the financial markets outweighs the benefits. These benefits are worth considering because they eradicate the fear of unfamiliarity in financial markets; hence more people can participate. Overconfidence also makes investors research more on the assets, which leads to more actively trading due to the signals.
Return predictability is better explained using overconfidence based models rather than market efficiency theory. The efficient market approach assumes that the prices reflect the performance of organizations, and those investors will use the provided information to make rational financial decisions. Overconfidence based models disagree with this theory because the assets momentum in the market is greatly influenced by investors overreacting to the information provided and the slow rectifications of prices. This is evident because investors neglect essential details in the financial statements that are essential for predicting future returns. Investors tend to purchase assets that provide good news to continue generating higher returns, whereas stocks with bad news make lower returns.
In the market efficient theory, investors are rational and analyze the information available correctly. Following this theory, assets prices should depict the performance of the organizations, and investors should get returns close to what they had predicted. Overconfidence based models explain that investors choose portfolios that they anticipate will generate more profits. Overconfident investors tend to overreact when the signal is regarded as private. Overreaction generally causes the prices to be overvalued within a short duration, which then falls after a day. Overconfidence is reinforced when an investor continuously predicts assets that generate high returns. The positive feedback from people boosts their confidence; hence investors participate more in financial markets. This causes investors to assess the success generated from the private signals. If the signals are consistent investors relies on them to make future trades. This irrational behaviour causes the prices of specific assets to be overpriced.
On the other hand, when investors use a private signal that generates low returns, they tend to lose confidence in the secret signals. Rational investors help to regulate the effects caused by overconfident investors. Prudent investors analyze the movements of the prices of the assets and act accordingly to secure their investment. This counteracts the effects caused by the private signals that overconfident investors use that causes abnormal rise or fall of prices.
The paper challenged the models that assumed investors made rational decisions in financial markets and outlined the possible reasons for actively trading that generated low returns. Overconfidence based models clearly explained the investors’ behaviours that caused a rapid increase in the volumes traded. This showed the significance of including overconfidence in the asset pricing models. Overconfidence brings the aspect of behavioural finance that explains the behaviours of investors. It offers explanations of the various investors’ disagreements despite sharing the same information. Overconfidence also explains why investors trade aggressively using other investors opinions. This model shows how investors’ decisions affect the assets’ prices. Overconfidence should be utilized in analyzing the rapid rise of assets traded in financial markets.