行为金融学9.doc

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CHAPTER 9: Discussion Questions and Problems

1. Differentiate the following terms/concepts:

a. Indirect and direct tests of relationship between overconfidence and trading activity

Indirect tests are usually based on trading activity and the fact that theoretical models link overconfidence and trading activity. Direct tests are usually experimental and they provide a direct link between overconfidence and trading activity.

b. Sensation seeking and overconfidence

Overconfidence in its various manifestations has been extensively discussed in the chapter. Sensation-seeking on the other hand is a personality trait whose four dimensions are thrill and adventure seeking (i.e., a desire to engage in thrilling and even dangerous activities); experience seeking (i.e., the desire to have new and exciting experiences, even if illegal); disinhibition (i.e., behaviors associated with a loss of social inhibitions); and boredom susceptibility (i.e., dislike of repetition of experience).

c. Underdiversification and excessive trading

Trading is only excessive when it leads to deterioration in portfolio performance. This is when its cost exceeds its benefit. Under-diversification is holding too few securities in your portfolio, so that most gains from diversification are not achieved.

d. Statics and dynamics of overconfidence

Right now most people would be judged overconfident (in its various manifestations) if they were tested. This is a snapshot (or statics) issue. The question is whether people become less or more overconfident over time based on their experience. This is a dynamics issue.

2. Consider two investors (A and B) with the following demand curves for a stock:

A: p = 100 - q
B: p = 150 – 2q

a. At a price of $50, how much will A and B purchase?

Substituting $50 into the above demand functions gives us q=50 for A and q=50 for B as well.

b. If the price falls to $30, who will increase their holdings more? Explain.

Now we redo the exercise for a price of $30. Now q=70 for A and q=60 for B. To go from 50 units, A would have to buy 20 and B would have to buy 10 units.

c. On this basis, which investor seems to more overconfident?

In terms of overconfidence, it could be said that A is more overconfident than B.

3. Discuss what the evidence (using naturally-occurring data, survey data, and experimental data) suggests about the relationship among overconfidence, trading activity, and portfolio performance.

Most of the evidence indicates that overconfidence leads to greater trading activity. It is appropriate to use the word “excessive” because this trading leads to poorer portfolio performance. The evidence is mixed on what manifestation of overconfidence (miscalibration vs. the better-than-average effect) contributes the most.

4. What evidence is there that people do not diversify enough? Why is it that this occurs? What is the simplest way to “buy” a high level of diversification in an equity portfolio?

In one study 3,000 U.S. individual portfolios were examined. Most held no stock at all. Of those households which did hold stock (more than 600), it was found that the median number of stocks in portfolios was only one. And only about 5% of stock-holding households held 10 or more stocks. Most evidence says that to achieve a reasonable level of diversification, one has to hold more than 10 different stocks (preferably in different sectors of the economy). Thus it seems clear that many individual investors are quite underdiversified.

Some have linked underdiversification to overconfidence. Those who traded the most also tended to be the least diversified. It is arguable that this is because overconfidence is the driving force behind both excessive trading and underdiversification.

The simplest way to “buy” diversification is to buy an index product.

5. Research indicates that stock market forecasters are also overconfident. Do they learn from their mistakes? Discuss.

In one study, the forecasts of a group of German market practitioners were examined. These individuals were asked to provide both forecasts for the future level of the DAX (the German counterpart to the Dow) and 90% confidence bounds. This respondent group was egregiously overconfident. Their dynamic behavior, however, seemed more in line with rational learning than self-attribution bias because respondents narrowed their intervals after successes as much as they widened them after failures. At the same time this research found that market experience made overconfidence worse, which is more consistent with a “learning to be overconfident” view and self-attribution. A likely reason for this is that experience is a double-edged sword. While we learn about our abilities (or lack thereof) from experience, those surviving in financial markets often have done so because of a run of success (good luck?) which has reinforced overconfidence through self-attribution bias.

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