Behavioral Issues Overconfidence Simon Gervais Duke University - PowerPoint PPT Presentation

Behavioral Issues – Overconfidence Simon Gervais Duke University (sgervais@duke.edu) June 29, 2019 FTG Summer School – Wharton School

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 2 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Lecture Overview Psychology in Finance . Behavioral/cognitive biases: Overconfidence, atribution bias, optimism and wishful thinking, ambiguity aversion, recency bias, loss aversion, regret aversion, etc. Lead to biased financial decision-making: Trading, financial investments, diversification, real investment, corporate policies, etc. Psychology and Overconfidence . DeBondt and Thaler (1995): “[P]erhaps the most robust finding in the psychology of judgment is that people are overconfident.” Fischhoff, Slovic and Lichtenstein (1977), Alpert and Raiffa (1982): People tend to overestimate the precision of their knowledge and information. Svenson (1981), Taylor and Brown (1988): Most individuals overestimate their abilities, see themselves as beter than average, and see themselves beter than others see them. Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 3 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Lecture Overview (cont’d) Who’s Impacted? Griffin and Tversky (1992): Experts tend to be more overconfident than relatively inexperienced individuals. Einhorn (1980): Overconfidence is more severe for tasks with delayed and vaguer feedback. Many fields: investment bankers (Staël von Holstein, 1972), engineers (Kidd, 1970), entrepreneurs (Cooper, Woo, and Dunkelberg, 1988), lawyers (Wagenaar and Keren, 1986), managers (Russo and Schoemaker, 1992). Lecture Objectives . Development of a theoretical framework to model overconfidence. Study the impact of overconfidence in financial markets and firms. Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 4 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Lecture Topics 1. Overconfidence in Financial Markets . Models of financial markets Modeling overconfidence. Effects of overconfidence in financial markets (trading volume, volatility, price paterns, price informativeness, etc.). 2. The Emergence of Overconfidence . Atribution bias as the source of overconfidence in financial markets. Dynamic paterns of overconfidence. Survival/impact of overconfident traders. 3. Overconfidence in Firms . Promotion tournaments as the source of overconfidence in firms. Impact on real investment decisions. 4. Overconfidence and Contracting . Principal-agent model with overconfident agent. Compensation contracts for overconfident agents. Labor markets and welfare consequences of agent overconfidence. Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 5 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion References Alpert, Marc, and Howard Raiffa, 1982, “A Progress Report on the Training of Probability Assessors,” in Daniel Kahneman, Paul Slovic, and Amos Tversky, eds.: Judgment Under Uncertainty: Heuristics and Biases (Cambridge University Press, Cambridge and New York). Cooper, Arnold C., Carolyn Y. Woo, and William C. Dunkelberg, 1988, “Entrepreneurs’ Perceived Chances for Success,” Journal of Business Venturing , 3(2), 97–108. DeBondt, Werner F. M., and Richard H. Thaler, 1995, “Financial Decision-Making in Markets and Firms: A Behavioral Perspective,” in Robert A. Jarrow, Voijslav Maksimovic, and William T. Ziemba, eds.: Finance, Handbooks in Operations Research and Management Science (North Holland, Amsterdam). Einhorn, Hillel J., 1980, “Overconfidence in Judgment," New Directions for Methodology of Social and Behavioral Science , 4(1), 1–16. Fischhoff, Baruch, Paul Slovic, and Sarah Lichtenstein, 1977, “Knowing with Certainty: The Appropriateness of Extreme Confidence,” Journal of Experimental Psychology , 3(4), 552–564. Griffin, Dale, and Amos Tversky, 1992, “The Weighting of Evidence and the Determinants of Confidence,” Cognitive Psychology , 24(3), 411–435. Kidd, John B., 1970, “The Utilization of Subjective Probabilities in Production Planning,” Acta Psychologica , 34, 338–347. Russo, J. E., and Paul J. H. Schoemaker, 1992, “Managing Overconfidence,” Sloan Management Review , 33(2), 7–17. Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 6 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion References (cont’d) Staël von Holstein, Carl-Axel S., 1972, “Probabilistic Forecasting: An Experiment Related to the Stock Market,” Organizational Behavior and Human Performance , 8(1), 139–158. Svenson, Ola, 1981, “Are We All Less Risky and More Skillful Than Our Fellow Drivers?,” Acta Psychologica , 47(2), 143–148. Taylor, Shelley E., and Jonathon D. Brown, 1988, “Illusion and Well-Being: A Social Psychological Perspective on Mental Health,” Psychological Bulletin , 103(2), 193–210. Wagenaar, Willem, and Gideon B. Keren, 1986, “Does the Expert Know? The Reliability of Predictions and Confidence Ratings of Experts,” in Erik Hollnagel, Giuseppe Mancini, and David D. Woods, eds.: Intelligent Decision Support in Process Environments (Springer, Berlin). Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 7 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 8 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Section 1 Overconfidence in Financial Markets Terrance Odean (1998) “Volume, Volatility, Price, and Profit When All Traders Are Above Average” Journal of Finance , 53(6), 1887–1934 Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 9 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Odean ( Journal of Finance , 1998) Objective : Study the impact of overconfidence on financial markets. Modeling Strategy . Three different models. ◦ Diamond and Verrecchia (1981): Rational expectations with an infinite number of price-taking agents. ◦ Kyle (1985): Strategic insider interacting with noise traders and a market-maker. ◦ Grossman and Stiglitz (1980): Rational expectations model in which agents decide whether or not to acquire information. Overconfidence. ◦ Signal = Truth + Noise. ◦ Overconfident agents underestimate the variance of noise. Main Results . Consistent across models: OC ↑ → Trading Volume ↑ , Market Depth ↑ , Welfare ↓ . Effect of OC on Volatility and Price Informativeness depends on the model. This Lecture : Hybrid of Diamond/Verrecchia (1981) and Grossman/Stiglitz (1980). Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 10 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Model Setup Economy . One period: trading at time 0, payoffs at time 1. Two securities. ◦ Risk-free security: r f = 0 , price normalized at 1, infinite supply. v ∼ N ( 0 , h – 1 ◦ Risky stock: End-of-period payoff of ˜ v ) , Price p at time 0 (to be endogenized), Supply of z > 0 . Market Participants . Two traders, price-takers (or two types, each with a mass of 1). CARA utility over end-of-period wealth: U i ( W ) = − e − rW , i ∈ { 1 , 2 } . Each endowed with ◦ f 0 units of risk-free asset and ◦ x 0 ≡ z 2 shares of risky stock. Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 11 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Information and Overconfidence Information . Each trader i ∈ { 1 , 2 } gets a signal about ˜ v : ε i ∼ N ( 0 , h – 1 y i = ˜ ˜ v + ˜ ε i where ˜ i ) . Assumptions: Cov (˜ v , ˜ ε i ) = 0 , Cov (˜ ε 1 , ˜ ε 2 ) = 0 . h i is signal precision: h i ↑ → Var (˜ y i ) ↓ → ˜ y i is “closer” to ˜ v . Overconfidence . Trader i believes that the precision of his signal is ˆ h i = ( 1 + κ i ) h i , where κ i ≥ 0 is his overconfidence . Trader 1 correctly assesses h 2 , and vice versa (“agree to disagree”). Notation: Biased expectations and variances by trader i will be denoted ˆ E i and ˆ Var i . Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 12 / 98

Intro OC in Markets Emergence of OC OC in Firms Contracting with OC Conclusion Equilibrium Definition Trader Decisions . Trader i chooses portfolio: ◦ f i units of risk-free securities, ◦ x i shares of stock (i.e., buys x i − x 0 shares). Beginning-of-period wealth. ◦ W 0 = f 0 + x 0 p before trading. ◦ W 0 = f i + x i p afer trading. ◦ Budget constraint (BC): f i = f 0 − ( x i − x 0 ) p . ˜ (BC) End-of-period wealth: W i = f i + x i ˜ v = f 0 − ( x i − x 0 ) p + x i ˜ v . Equilibrium : { ˜ x 1 , ˜ x 2 , ˜ p } is an equilibrium if x i maximizes trader i ’s (biased) expected utility conditional on all his information: ˜ � � � ˆ � ˜ U i ( ˜ y i , ˜ x i = arg max ˜ E i W i ) p x i The market for shares of stock clears: ˜ x 1 + ˜ x 2 = z . Behavioral Issues – Overconfidence | FTG Summer School – June 29, 2019 13 / 98