Question

There is evidence that the overconfidence of investors leads to excessive trading. Explain this phenomenon with a simple illustrative model that relates overconfidence and trading activity?

Answer 1

Overconfidence of the investor will be leading to excessive trading due to having belief that they can make a higher amount of money because traders and investors will feel that their data and analysis are superior to others and they are having sufficient knowledge regarding analysis of the stocks and according to their knowledge, they have the edge in making a higher return and this theory is house money effect.

House money effect will be representing that investors are likely to take a higher amount of risk going forward because they are becoming less risky as they are spending more time in the market because they feel that they are very familiar with the movements of the market and their analysis is superior to others and they can make better investments by their unique analysis and hence, due to these optimism and delusion of being superior, investor are trading in higher quantity in order to make a higher rate of return.

It can be exampled through when investor who is continuously making money in same stock will be continuously raising his exposure in making money, as he is growing more confident as his analysis is going the right way so he will be increasing his greed to make a higher rate of return.