3literature review of behavioral fianance13!05!2013 by daniel

7/30/2019 3Literature Review of Behavioral Fianance13!05!2013 by Daniel

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The Impact of Overconfidence / Confirmation bias in Decision Making

The evidence from stock exchange of Pakistan

Introduction:

The overconfidence has been widely documented in psychology and has become a central

feature in economics and behavioral finance. There are many biases that are source of

overconfidence (i.e. self-attribution, anchoring and adjustment, illusion of control etc.) these

drive the investors to be overconfident. Overconfident investors are known to trade more

frequently and have negative abnormal returns amongst stock market traders, especially when

they are less experienced yet successful (Odean 1998, Barber and Odean 2001).

A series of experiments in the 1960s suggested that people are biased toward confirming

their existing beliefs. Later work re-interpreted these results as a tendency to test ideas in a one-

sided way, focusing on one possibility and ignoring alternatives. In certain situations, this

tendency can bias people's conclusions. Explanations for the observed biases include wishful

thinking and the limited human capacity to process information. Another explanation is that

people show confirmation bias because they are weighing up the costs of being wrong, rather

than investigating in a neutral, scientific way. Confirmation biases contribute to overconfidence

in personal beliefs and can maintain or strengthen beliefs in the face of contrary evidence. Poor

decisions due to these biases have been found in military, political, and organizational contexts.

Confirmation bias (also called confirmatory bias or my side bias) is a tendency of people

to favor information that confirms their beliefs or hypothesis. People display this bias when they

gather or remember information selectively, or when they interpret it in a biased way. The effect

is stronger for emotionally charged issues and for deeply entrenched beliefs. For example, in

reading about gun control, people usually prefer sources that affirm their existing attitudes. They

also tend to interpret ambiguous evidence as supporting their existing position. Biased search,

interpretation and memory have been invoked to explain attitudes polarization (when a

disagreement becomes more extreme even though the different parties are exposed to the same


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evidence), belief perseverance (when beliefs persist after the evidence for them is shown to be

false), the irrational primacy effect (a greater reliance on information encountered early in a

series) and illusory correlation (when people falsely perceive an association between two events

or situations).

It has been consistently observed that people are generally overconfident in judgment and

decision making. Overconfidence decision making has been observed in financial markets

(Odean, 1998), corporations (Malmendier & Tate, 2005), with business entries (Cooper, Woo, &

Dunkelberg, 1988) or even marriages (Mahar, 2003). Overconfidence is not just an artifact of

psychological experiments but seems in our real life situation. Researchers also find that the

people overestimate their abilities to predict the future outcome with the personal importance of

the task.(Frank 1935). People are also unrealistically optimistic about future events.(Weinstein

1980, Kunda 1987).

When an investor or rational person choose a best investment opportunity between A

and B. A security providing 50% chance of loss and 50% gain but B security providing 40% gain

and 60% chances for loss but insurance claim is also 0.3% on any damage or loss and Investor is

riskier or arbitrager. On other side Investor has risk averse behavior. The purpose of investment

means high return but without taking high risk how it is possible. A rational man (decision

Maker) Choose the B security due to insurance claim is available against any loss or damage.

The asymmetry between the two options in this situation could introduce systematic biases.

Indeed,( Lichtenstein and Slovic) have constructed pairs of prospects A and B, such that people

generally preferB over A, but A is more clear thanB. This phenomenon has been confirmed in

several studies,(Grether and Plott). Because prospect theory has been proposed as a model of

choice, the inconsistency of A and B and choices implies that the measurement of values and

decision weights should be based on choices between specified prospects.

Decision-making is sensitive to the description of the action choices, that is, to the way

the alternatives are 'framed' [Tversky & Kahneman, 1981]. For example, a store that offers cash

customers a discount is less likely to upset its credit card clientele than another store with the

same prices -- that imposes a credit card surcharge [Thaler, 1980]. Individuals also have


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opportunities to create their own frames, a process called mental accounting [Thaler, 1985].

Consider, e.g., an investor holding 1000 shares each of two stocks,both with a current price of

$10 per share. One stock was purchased at $5, the other at $13. If the investor contemplates

selling the stocks separately he may resist selling the loser because of loss aversion, but if the

two transactions are combined, producing a net gain, no loss need be felt. Previous studies tells

us about the conflict between decision making and cognitive biases but the problem is this

overconfidence and confirmation bias how supportive or conflict with each other in investment

context and predict the future outcome.

The investors hold mistaken beliefs about the mean, of the precision of the distribution of

their information. If these traders believe they have information, but actually have none, the

securities they buy will perform, on average, about the same as those they sell, before in the

context of transaction cost.(Prospect theory 1979). An important implication of prospect theory

is that the way economic agents subjectively frame an outcome or transaction in their mind

affects the utility they expect or receive. Thepseudo certainty effect (It refers to people's tendency to

perceive an outcome as certain while in fact it is uncertain (Kahneman & Tversky, 1986).It is observed in

multi-stage decisions, in which evaluation of outcomes in previous decision stage is discarded when

making an option in subsequent stages) is the observation that people may be risk-averse or risk-

acceptant depending on the amounts involved and on whether the gamble relates to becoming

better off or worse off.

In the contrary, psychological effect have great influenced in investment decision making

in stock market, in the context of high risk and high return but still people with risk averse

behavior invest in stock exchange instead of risk free securities. We want to contribute in the

contextual study prior than previous.This study extends this behavioral literature and develops

several hypotheses motivated primarily by the psychology literature on confirmation bias. It is

fact that a lot of studies have already done on this subject but in this study tries to evaluate the

stock market and investment behavior of the investor and find the empirical solution to debiase.

Prior studies in accounting and finance suggest that virtual communities often provide

more accurate information than analyst forecasts (Bagnoli et al 1999, Clarkson et al. 2006). Early

evidences of Enron collapse from accounting tricks were first reported in message boards


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(Felton and Kim 2002). Groups of people interacting through computer-mediated

communication have become common within organizations and society. These groups can range

from the professional(e.g., AoIR, the listserv for association of Internet researchers) to the social

(e.g., Honda motorcycle enthusiasts on Yahoo groups). They can form on a variety of interactive

communication technologies including listservs, newsgroups and bulletin boards, chatrooms and

even blogs. Although the technologies and specific topics vary, what is common to these online

groups is the members public exchange of information and support (Jones, 1997).

Some studies show that the volume of posts or the level of investor sentiments in

virtual communities has a positive relation with market activity (e.g., trading volume or

volatility) (Antweiler and Frank 2004, Bagnoli et al. 1999, Das and Chen 2007, Tumarkin

and Whitelaw 2001).The role of virtual community in decision making is providing more

accurate information than financial market but any conflict between virtual community and

investor behavior ( individual and arbitrager ) also providing information and analyze the

securities and invested. These all decisions have been analyze at the time of reinvestment.

On the contrary, psychological studies indicate that virtual communities may not

necessarily make investors more informed or lead to better investment performance. In

particular, the behavioral finance literature shows that psychological biases, particularly in

an uncertain and noisy environment, influence investors information processing behavior

(Kahneman and Riepe 1998, Barber and Odean 2001). It will examine that whether

psychological factors influence how individuals process information and whether such

behavior in turn influences their investment expectations and actual performance. This

study is going to check the impact and relationship between overconfidence and confirmation

bias in stock market.

This study helpful for investor. Investor may take a cue of these behavioral biases and

their impact on stock exchange performance/return of investment, so that decision can be taken

accordingly. This study helpful in a sense that investor control this confirmatiom and

overconfidence bias in order to achieve beter performance of stock exchange in Pakistan if

relationship exist.


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Literature review:

The literature on overconfidence has broadly investigated its impact on financial

decision-making, mainly focused on financial markets and trader behavior. The Overcofidence

have major three consequences of too much trade Barber & Odean, 2000; Glaser & Weber,

2007; Kim & Nofsinger, 2002; Odean,1999; Statman, Thorley, & Vorkink, 2004, excessive

volatility (volatility is a measure for variation of price of a financial instrument over time. Historic

volatility is derived from time series of past market prices) In this area researcher wants to tell the

results of excessive volatility is the main proof of overconfidence in decision making by Daniel,

Hirshleifer, & Subrahmanyam, 1998; Gervais & Odean, 2001 and a combined phenomenon of

under-and overreaction to information (under reaction of stock prices to news such as earnings

announcements, and overreaction of stock prices to a series of good or bad news) Daniel &

Titman, 1999; Daniel et al., 1998; Glaser &Weber, 2007; Lee & Swaminathan, 2000.

The investor is an individual and riskier arbitragers have not escape from overconfidence

in decision making and they have inappropriate decisions when they invest in securities. In

corporate finance, important impacts have been observed such as over-investment or preference

for debt financing Malmendier & Tate, 2005. It is confirmed that overconfidence behavior is

along with the decision maker because they are human being. A person in behavioral finance isnormal but not rational

It is well accepted that decision makers are often influenced by multiple

psychological biases that distort their decision making and economic outcomes Barber and

Odean 2001, 2002, Kahneman and Riepe 1998, Raghunathan and Corfman 2006. Barber and

Odean (2001) argued that the illusion of control (e.g., people believe that they can

influence the outcome of chance events), the illusion of knowledge (e.g., when people have

far more data, they believe that they are more knowledgeable than they really are), and self;

attribution bias (e.g., people tend to attribute their success to their own abilities while attribute

their failure to bad luck. Overconfident investors are known to trade more frequently and have

negative abnormal returns amongst stock market traders, especially when they are less

experienced yet successful Odean1998, Barber and Odean 2001. In short, the evidence on the


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dynamics of overconfidence is mixed and subject to interpretation. Nevertheless, given that there

is abundant evidence that overconfidence is a pervasive phenomenon and certainly difficult to

unbias Fischhoff (1982), and that so many financial behaviors have been linked theoretically

and empirically to the phenomenon. People tend to seek or interpret evidence in ways that are

favorable to the beliefs or expectations they hold.

This phenomenon is called confirmation bias and has been found in many contexts, both

in laboratory and real-world settings Nickerson, 1998; Oswald & Grosjean, 2004. Recent

research, for instance, has found that confirmation bias provides an explanation as to why

citizens tend to maintain their political beliefs Taber & Lodge, 2006 or their beliefs regarding

gender roles Marks & Fraley, 2006. The confirmation bias is also an explanation as to why

expectations of guilt may lead to a self-fulfilling prophecy effect when law enforcement officers

gather information in criminal investigations Hill, Memon, & McGeorge, 2008. Any positive or

negative expectation about circumstances, events, or people that may affect a person's behavior

toward them in a manner that causes those expectations to be fulfilled. The impact of

confirmation bias is highly supported to overconfidence in self-fulfilling prophecy.

Where people seek out and interpret information that is consistent with their expectations

Koriat, Lichtenstein, & Fischhoff, 1980; Nickerson, (1998). Past reviews on the confirmation

bias have conceptualized it as a cognitive shortcut or heuristic that simplifies complex inferential

tasks Friedrich,1993;MacCoun, 1998. Because people assume that their existing beliefs are true,

those beliefs serve as a heuristic for evaluating new information. However, the confirmation bias

may also lead to poorer decisions because evidence is not being considered fully. For example,

when children in a video were given a label of high or low socio-economic status, people used

that label to make judgments of future academic ability, disregarding other relevant information

Darley & Gross, 1983. In particular, the behavioral finance literature shows that

psychological biases, particularly in an uncertain and noisy environment, influence investorsinformation processing behavior Kahn man and Riepe 1998, Barber and Odean 2001. The impact

of confirmation bias on decision making is some time high and low output from expected return.

Decision making is mental processes (cognitive process) resulting in the selection of a

course of action among several alternative scenarios. The output can be an action or an opinion
http://www.investorwords.com/14646/person.htmlhttp://www.businessdictionary.com/definition/behavior.htmlhttp://www.businessdictionary.com/definition/cause.htmlhttp://www.businessdictionary.com/definition/expectation.htmlhttp://en.wikipedia.org/wiki/Cognitionhttp://en.wikipedia.org/wiki/Cognitionhttp://www.businessdictionary.com/definition/expectation.htmlhttp://www.businessdictionary.com/definition/cause.htmlhttp://www.businessdictionary.com/definition/behavior.htmlhttp://www.investorwords.com/14646/person.html


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of choice. Bounded rationality is the idea that in decision-making, rationality of individuals is

limited by the information they have, the cognitive limitations of their minds, and the finite

amount of time they have to make a decision. The concept of bounded rationality revises this

assumption to account for the fact that perfectly rational decisions are often not feasible in

practice because of the finite computational resources available for making them. Information

Overload is when there is a substantial gap between the capacity of information and the ways

we adapt. The overload of information can be related to problems processing and tasking. Above

all evidence regarding overconfidence and confirmation bias in decision making is more

complicated. Prior researches have been conducted by different aspects of behavior but not

provide the unbiased methodology to investor/arbitrager. It is more difficult to find these results

which I provide to Pakistani Investor/arbitrager. But my insight to investigate and providing the

better solution to Pakistani stock exchanges investor/arbitrager and make the good decision

making in the context of overconfidence and confirmation bias.

3literature review of behavioral fianance13!05!2013 by daniel

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