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Investors are subject to a variety of psychological tendencies that do not fit with the economists’ ‘rational man’ model. This, it is argued, can lead to markets being heavily influenced by investor sentiment.
The combination of limited arbitrage and investor sentiment pushing the market leads to inefficient pricing. Both elements are necessary.
If arbitrage is unlimited then arbitrageurs will offset the herd actions of irrational investors so prices quickly and correctly move to incorporate relevant news.
In the absence of investor sentiment prices would not move from fundamental value in the first place. Listed below are some of the psychological tendencies that are thought to impact on investors’ buying and selling decisions and thus to create sentiment.
Overconfidence
When you ask drivers how good they are relative to other drivers research has shown that 65–80 per cent will answer that they are above average.
Investors are as overconfident about their trading abilities as about their driving abilities. People significantly overestimate the accuracy of their forecasts.
So, when investors are asked to estimate the profits for a firm one year from now and to express the figures in terms of a range where they are confident that the actual result has a 95 per cent chance of being within the projected range, they give a range that is far too narrow.
Investors make bad bets because they are not sufficiently aware of their informational disadvantage. This line of research may help explain the under-reaction effect – see Newsletters dated 12/13 October.
Investors experience unanticipated surprise at, say, earnings announcements because they are overconfident about their earnings predictions. It takes a while for them to respond to new information in the announcement (due to conservatism – discussed in tomorrow’s Newsletter) and so prices adjust slowly. This may contribute to price momentum and earnings momentum.
Overconfidence may be caused, at least in part, by self-attribution bias. That is, investors ascribe success to their own brilliance, but failures in stock picking to bad luck.
Overconfidence may be a cause of excessive trading because investors believe they can pick winners and beat the market (Barber and Odean, 1999, 2000, Puetz and Ruenzi (2011)).
Inexperienced investors are, according to the research, more confident that they can beat the market than experienced investors.
Representativeness
Representativeness is the …………..
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