FINC 6022 Behavioural Finance L5

2681 Words Jun 14th, 2015 11 Pages
FINC 6022 Behavioural Finance
Lecture 5: Overconfidence

Lecturer: Andrew Grant

› Overconfidence: Belief in one’s ability that is not justified by actual skill
› How do we identify overconfidence?
- Miscalibration in judgemental intervals
- Better-than-average effect

› Miscalibration can manifest itself in estimates of quantities that could potentially be discovered (e.g. the length of the Nile River)
› Or in estimates of not-yet-known quantities (e.g. the future price of a stock or the future value of a stock index).
› The following fractile method may be used to measure the degree of miscalibration in interval estimates:
- Please give the following estimates for your prediction.
- The true answer to the questions (e.g. a
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› Glaser, Weber and Langer (2009) obtain similar results for students and professional stock traders.

Basic Facets
› When real financial time series are forecasted within a particular time window, hit rates are problematic because the development of stock prices of different firms is not independent
› Consider an investor who predicted in July 2001 that a set of stocks will increase slightly until the end of the year, with error bounds around a median forecast that correspond to historical stock price volatility.
› After September 11, 2001, such an investor would have been classified as extremely overconfident, although the ex ante prediction looked quite reasonable. › This is why several studies compare the volatility expectation implied by the width of the stated confidence interval with a reasonable benchmark such as the historical volatility or the volatility implied by the option market.
- Different benchmarks for volatility only affect the amount of overconfidence measured by a researcher, but not the ranking of people with respect to their degree of overconfidence.

How else do we measure overconfidence?
› Other studies ask subjects to answer questions with two choices to measure the degree of miscalibration. Subjects are then asked to state the probability that their answer is correct. E.g.
- Who was born first, Charles Darwin or Charles Dickens?
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