OVERCONFIDENCE AND RISK
Overconfidence also affects risk-taking behavior. Rational investors try to maximize returns while minimizing the amount of risk taken. However, overconfident investors misinterpret the level of risk
The portfolios of overconfident investors will have
1.-1 you are confident that
higher risk for two reasons. First is the tendency of the stocks you pick will
overconfident investors to purchase higher risk
stocks. Higher risk stocks are generally from smaller then where is the risk?
and newer companies. The second reason is a ten
Lets return to the
dency to underdiversify the portfolio.
overconfident Iomega
true believers. William Bronsteen posted that his entire IRA - A sum worth around $250,000 - was invested in Iomega shares. Barry Brewer, another supporter and retired carpenter, invested in Iomega shares with his family to the tune of $2 million.
An entire portfolio invested in the stock of one small company? A person in retirement betting the farm on one small company? Overconfidence can clearly lead to risky behavior!
At the time of these postings, Iomega stock was at a split-adjusted price of about $9 a share. Over the next couple of months, Iomega skyrocketed to $22 a share and then plunged right back to $9. Over the next three years, Iomega rode a roller coaster ride to settle at around $4 a share. Did these overconfident investors get out in time? Unfortunately, psychological biases discussed later (like avoiding regret in Chapter 5) often inhibit you from correcting a mistake.
William and Barry are extreme examples. Your overconfidence probably leads to much less dramatic risk-taking behavior. There are several measures of risk you should consider:
■ Portfolio volatility - measures the degree of ups and downs the portfolio experiences. High-volatility portfolios exhibit dramatic swings in price and are indicative of under diversification.
■ Beta - a variable commonly used in the investment industry to measure the riskiness of a security. It measures the degree a portfolio changes with the stock market. A beta of one indicates that the portfolio closely follows the market. A higher beta indicates that the security has higher risk and will experience more volatility than the stock market in general.
■ Company size - the smaller the size of the companies in the portfolio, the higher the risk.
The series of studies by Barber and Odean show that overconfident investors take more risk. They found that single men have the highest risk portfolios fol 0yera|| fls an overconffidenl jnveslor( you percejve lowed by married men, your aclions l0 be |ess risky lhan genera||y proves
married women, and sin- |§ be fle case
gle women. Specifically,
the portfolios of single men have the highest volatility, highest beta, and include smaller companies. For the five groups of investors sorted by turnover, the high-turnover group invested in stocks of smaller firms with higher betas compared to the stocks of the low-turnover group.
OVERCONFIDENCE AND EXPERIENCE
As discussed in the last chapter, overconfidence is learned. However, it may not take long to learn it. A study administered by the Gallup Organization and designed by PaineWebber Group, Inc., examined the role of experience in investor expectations. The survey was done in 1998 when the stock market was near record highs. They found that new, or inexperienced, investors expected a higher return on their investments than the return expected by much more experienced investors. Additionally, the inexperienced investors were more confident about their ability to beat the market.4
Apparently having been around the block a time or two and having experienced both bull and bear markets help more seasoned investors to unlearn some of the overconfidence.
Mutual Funds
Maybe the solution to this problem is to have professionals invest your money. If you are considering this, remember that professional money managers are people too! They are subject to the same psychological influences as everyone else. Does their education and experience help them overcome the psychological influences of over-confidence?
Unfortunately, this may not be the case. Professional investors can be overconfident too. In fact, psychologists have shown that, in a field in which predicting the future is hard, as it is with investing, experts maybe even more prone to overconfidence than novices.
Mutual funds are a good example. During the period from 1962 to 1993, stock mutual funds experienced an average annual turnover of 77%. For the funds delivering the best performance (the highest 10% of all funds) in one year, the turnover rate then increased to 93% the next year. A successful mutual fund begins trading more. Is this overconfidence or is it skill? Apparently it is overconfidence. Having success one year leads to overconfidence. This can be seen by the increase in turnover the next year.
The overconfidence also shows up in the returns. The average fund underperforms the market by 1.8% per year.5 Mutual funds cannot own too much of a firm (SEC rule). So if the fund has a lot of dollars to invest, it would have to buy larger firms to avoid breaking the SEC rule. These institutional investors also like to purchase risky stocks.6 Due to the large size of most institutional portfolios, professional money managers are forced to purchase the stock of large companies. However, they tend to pick the large stocks that have higher risk (measured in volatility) - again, a sign of overconfidence.
OVERCONFIDENCE AND THE INTERNET
Thanks to the Internet, "high-quality" information is now easier and quicker to obtain than ever before. However, the Internet investing environment fosters overconfidence. As you acquire more information, your confidence in your ability to predict the future rises far faster than your true ability. Online investors have access to vast quantities of data, but information is not knowledge or wisdom. In fact, having loads of data gives you the illusion of knowledge and thus control. Ultimately, this data may give you a false confidence that you can pick stocks. Indeed, the increase in trading volume in the stock market during the 1990s is often attributed to the rise in popularity of online trading. This has also coincided with the proliferation of online message boards, which seduce investors into the illusion of control.
Due to the illusion of control, investors often become even more overconfident after switching from traditional brokerage trading to online brokerage accounts. Barber and Odean studied the behavior of 1,607 investors who switched from phone-based trading to online trading.7 Even before going online, these investors were active traders - their average annual turnover was 70%. After the switch to online trading, their turnover increased to 120% annually. Was this extra trading fruitful? Before the switch, these investors performed well. Their portfolio returns (after costs) exceeded that of the major indices (like the S&P 500 index). After the switch to online trading, these investors began underperforming these indices. In short, it appears that they became more overconfident after switching to online trading accounts. This overconfidence led to excessive trading and lower profits (see Section 4 of this book for further discussion of these issues).
SUMMING UP
Both individual and professional investors can be overconfident about their abilities, knowledge, and future prospects. Overconfidence leads to excessive trading that can lower portfolio returns. Overconfidence also leads to greater risk taking. You may be accepting more risk due to underdiversification and a focus on investing in small companies with higher betas. Finally, investors ever increasing use of online brokerage accounts is making them more overconfident than ever before.
Indeed, trading in the U.S. stock market seems overly high. The average dollar amount of the stock traded on just the New York Stock Exchange in one year is roughly equivalent to one-quarter of the world's total annual economic trade and investment flow.
This article is part of eBook. To read the rest of the eBook (full version) please look at: return on investment
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