By LARRY SWEDROE
One of the questions I’m often asked by the media is “What are the biggest risks facing investors?” My usual response is that the biggest risk confronting most investors is staring at them in the mirror. Research from the field of behavioural finance, the study of human behaviour and how that behaviour leads to investment errors, as well as the mispricing of assets, demonstrates that investors aren’t always fully rational—they aren’t always “economically” logical in their actions, but what we can call “psycho” logical. And one of the biggest mistakes is that investors are overconfident of their skills.
Kent Daniel and David Hirshleifer, authors of the paper Overconfident Investors, Predictable Returns, and Excessive Trading, discussed the role overconfidence plays in investor returns. They cited a wealth of literature which demonstrates:
People tend to be over-optimistic about their life prospects, and this optimism directly affects their final decisions.
Overconfidence has been documented among experts and professionals, including corporate financial officers as well as professional traders and investment bankers.
Overconfidence includes over-placement (over-estimation of one’s rank in a population on some positive dimension) and over-precision (over-estimation of the accuracy of one’s beliefs). An example is the overestimation of one’s ability to predict stock market returns.
A cognitive process that helps support overconfident beliefs is self-attribution bias — people credit their own talent and abilities for past successes while blaming their failures on bad luck. Self-attribution bias allows overconfidence to persist. When investors “get it right,” they upgrade their confidence in their beliefs; when they “get it wrong,” they fail to downgrade it.
Individual investors trade individual stocks actively, and on average lose money by doing so. The more actively investors trade (due to overconfidence), the more they typically lose.
The stocks that individual investors buy tend to subsequently underperform, and the stocks they sell tend to subsequently outperform.
Actively managed funds that charge high fees without delivering correspondingly high performance provides evidence that most individual investors in active funds are overconfident about their ability to select high-performing managers.
Men are more overconfident than women in decision domains traditionally perceived as masculine, such as financial matters. Overconfidence leads to more trading. One study found that, consistent with higher confidence on the part of men, the average turnover for accounts opened by men is about 1.5 times higher than for accounts opened by women, and as a result, men pay almost one per cent per year more in higher transaction costs and their net-of-fee returns are far lower.
Individual investors tend to trade more after they experience high stock returns.
Overconfidence is likely to be especially important when security markets are less liquid and when short-selling is difficult or costly (i.e. limits to arbitrage are at work). When short-selling becomes constrained, pessimists find it harder to trade on their views than optimists, resulting in overpricing. Thus, when overconfidence is combined with constraints on short sales, we expect the security to become overpriced.
Overconfidence plays a greater role the more analysts disagree, as measured by the dispersion in their forecasts of a firm’s future earnings. Firms with the largest dispersion of forecasted earnings tend to become overpriced because the more pessimistic investors don’t express their views through trading. Thus, on average, these stocks earn lower returns.
Because volatility creates a greater scope for disagreement, the overpricing of more volatile stocks is more prevalent — high-idiosyncratic-volatility stocks earn lower subsequent returns than low-volatility stocks.
The latest contribution to the literature on confidence is from Brad Barber, Xing Huang, Jeremy Ko and Terrance Odean, authors of the August 2019 study Leveraging Overconfidence. They hypothesised that “overconfident investors with a budget constraint use leverage more, trade more, and perform worse than well-calibrated investors.” To confirm their hypothesis, they analysed the behaviour and performance of retail investors who use margin. Using survey data from the National Financial Capability Study administered by the FINRA Investor Education Foundation, they analysed responses of 1,601 respondents from the 2015 Investor Survey; 37 percent of them have a margin account and 18 percent have experience buying stock on margin. Survey respondents took two quizzes: a 10-question quiz that measures investment literacy, and a six-question quiz that measures financial literacy. Separately, respondents were asked to self-assess their investment knowledge and financial knowledge. They measured overconfidence in investment knowledge as the difference in a respondent’s percentile rank on self-assessed investment knowledge less the respondent’s percentile rank on the financial investment quiz. They found that investors who trade on margin have greater overconfidence than both investors with margin accounts but no margin experience and investors with cash accounts. For example, investors with experience trading on margin are at the 65th percentile in their self-assessed financial knowledge, but the 37th percentile on quizzed financial knowledge.
The authors then used an older data set that Barber had used in prior research. The data was from a large discount broker covering the period 1991 to 1996. They analysed the trading and performance for the non-retirement accounts of over 43,000 investors; 66 percent have only margin accounts, 34 percent have only cash accounts, and 13 percent have experience using margin. They found that margin account investors, but especially margin experience investors, trade more, and more speculatively, than cash investors. Note that some trading could be attributed to tax-loss selling, or sales not followed by another purchase (used to raise cash), neither of which would be considered speculative.
They also found that margin investors have worse security selection ability than cash investors. A long-short portfolio that follows the trades of margin investors loses 35 basis points per day. Cash investors did slightly better, losing “only” 25 basis points per day. The greater degree of overconfidence of margin investors not only led them to trade more often, but their stock-picking skills were even worse than the bad stock-picking skills of cash investors. The security selection skills of margin investors are so bad that their mean returns after buys were negative and returns after sells were positive. It was also interesting to note that margin investors tend to have higher incomes and wealth—their higher income levels and greater wealth may have contributed to their overconfidence.
The above findings are consistent with those of studies of retail foreign exchange traders. Rawley Heimer and Alp Simsek, authors of the study Should Retail Investors’ Leverage Be Limited? published in the June 2019 issue of the Journal of Financial Economics, found that “leverage-constraint reduces trading volume by 23%, alleviates high-leverage traders’ losses by 40%, and reduces brokerages’ operating capital by 25%.”
Barber, Huang, Ko and Odean added this important point: overconfidence is not limited to retail investors. They offered the example of Long-Term Capital Management (LTCM), which began by using only long-short strategies that were designed to exploit anomalies. However, likely due to overconfidence, they eventually added absolute-return trading strategies with high financial leverage. While initially successful, they ultimately resulted in $4.6 billion in losses in the wake of the 1997 Asian financial crisis.
They also noted that their results are applicable to other markets. For example, “in housing markets, where leverage is readily accessible and often used, overconfident homebuyers might use more leverage, speculate more, and thereby potentially facilitate the formation of a bubble.”
The authors concluded: “In sum, our evidence indicates that overconfidence — not better information — is a primary motivation for retail investors to trade, to their detriment, on margin. More generally, our analysis suggests overconfidence and leverage can be a dangerous mix.”
The findings of Barber, Huang, Ko and Odean are entirely consistent with prior research demonstrating that individual investors are overconfident about their ability, and trade to their detriment. Before you conclude that this is true of others, but not you, remember that the research demonstrates it doesn’t matter what the question is — whether you are a better-than-average driver, you are liked more by others than the average person, or you are smarter than average — the typical survey finds that 80 percent or more believe they are above average. Overconfidence is particularly dangerous to investors because it can lead to not only excessive trading, but also a failure to diversify sufficiently to minimise idiosyncratic risks for which investors are not compensated. Forewarned is forearmed.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
If you’re interested in reading more of his work, here are his other most recent articles for TEBI: