In financial markets, investment decision-making is said to be based merely on information reflected in the security's price, analysis of past performance of traded securities and forecasts of the future performance. The emergence of the behavioral side of finance in the early 1970s has put a huge emphasis that investors are not always rational and that each decision-making process is affected by both rationality and emotions. From a behavioral point of view, investors are affected by individual biases which prevent them from taking their investment decisions on a rational basis. One of the vital biases affecting rationality is the overconfidence bias, which has a huge influence on individual investors and financial markets. This article provides a review of the previous studies and research relating to overconfidence and its impact on individual investors in particular and financial markets in general, it also sheds light on Turkey as an empirical example and aims to discuss the previous works done in Turkey about this matter.
TopIntroduction
The birth of the behavioral finance field in the 1970s which was triggered by Kahneman’s and Tversky’s (1979) works on the Prospect Theory has led to an ongoing conflict between the scholars of the contemporary side of finance and the scholars of the behavioral side on the rationality of investors in making their investment decisions. Empirical studies on the behavioral side argue that investors are not rational in making their investment decisions (i.e. purchasing stocks and constructing their investment portfolios).
Kahneman and Tversky (1979) depart from the tradition that assumes that investors are rational; in their theory, they state that when facing complicated issues, investors (i.e. people) employ many mental shortcuts to simplify the presentation and evaluation of these issues. These shortcuts include cultural factors, religion, past experiences and social stereotypes. In their survey of behavioral finance Barberis and Thaler (2003) try to understand how investors construct their portfolios and make their investment decisions. They observe the effect of the investors’ beliefs, preferences and limits of arbitrage on the investor’s decisions and try to relate that with many issues observed in financial markets (i.e. aggressive trading, excess volatility and the ability to predict stock returns). Black (1986) argues that the very basic act of trading makes the existence of financial markets possible but at the same time makes them inefficient, in his work named “Noise”, Black argues that the uninformed trading of some investors and the reliance on investors’ psychological biases in making financial decisions have a major influence on security prices. There are several studies supporting this view and concluding that investors are not rational, they misapply rationality or even that markets are not efficient and therefore security prices may reflect a variation from the fundamental or initial values due to the uninformed trading or the presence of irrational traders.
One of the most pronounced and essential forms of misapplying rationality or departing from it in the behavioural finance literature and empirical side is overconfidence which has many effects on investors and financial markets. Overconfidence affects many aspects of the financial markets including the level of trade in the market, risk and the fluctuations in security prices. Overconfidence affects the trading behaviour of investors, it encourages them to trade more resulting in aggressive levels of trading volume. In addition to affecting the levels of trade, it affects the risk estimation ability of investors, overconfident investors underestimate risk therefore they end up engaging in riskier trading positions compared with their level of risk tolerance. The reflections of overconfidence do not only appear in financial markets and prices of securities, it also affects the well-being of individual investors as it causes them to make poor investment decisions which might be detrimental to their portfolio value. Therefore, it is of vital importance to perform further studies on overconfidence, the factors leading to it and the reflections and consequences expected to result due to its presence.
Many psychologists have tried to explain the factors that lead to overconfidence and relate these factors to the personal qualities of individual investors, for instance, Synder and Fromkin (1977) have concluded that the need of individual investors to be viewed as unique may initiate an overconfident behavior, Rosenberg (1965) have argued that high levels of self-respect may also lead to the expression of overconfidence.
Both psychologists and financial scholars divide overconfidence (about individual characteristics) into four components: over-precision, over-placement, overestimation of control and overestimation of positive results. While this model was initially created by psychologists, financial scholars such as Odean (1999) and Glaser and Weber (2007) utilize this model to investigate the existence of overconfidence among individual investors. Then they try to quantify and compute the main effects of overconfidence on financial markets.