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Scott Plous, professor of psychology at Wesleyan University and the author of The Psychology of Judgment and Decision Making, wrote, “No problem in judgment and decision making is more prevalent and more potentially catastrophic than overconfidence.” John Nofsinger, associate professor of finance at Washington State University, a specialist in behavioral finance, and the author of The Psychology of Investing, had this to say:
People are overconfident. Psychologists have determined that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events.Does overconfidence occur in investment decision making? Security selection is a difficult task. It is precisely this type of task at which people exhibit the greatest overconfidence.
In fact, studies have shown that the ratio of confidence to accuracy is an inverse one -- that is, a lesser confidence level tends to correlate with a higher degree of accuracy. A study released 10 days ago by Tadeusz Tyszka and Piotr Zielonka of the Leon Kozminski Centre for Market Psychology at the Academy of Entrepreneurship and Management in Warsaw, titled "Expert Judgments: Financial Analysts vs. Weather Forecasters," asked two groups of experts to “predict corresponding events (the value of the Stock Exchange Index and the average temperature of the next month).” Tyszka and Zielonka found that, “Although both groups of experts revealed the overconfidence effect, this effect was significantly higher among financial analysts than among the weather forecasters.” Their conclusion:
In the group of financial analysts one-third of the participants succeeded in their forecast and in the group of weather forecasters approximately two-thirds of the participants succeeded in their forecast. Further analysis showed that “Experts who assigned confidence estimates of 80% or higher were correct only in 45% of cases. As quoted by Korn & Laird (1999), a high level of overconfidence seems to be characteristic for finance analysts as well and most probably for many other kinds of experts."
In a slightly larger than usual nutshell, the crux of the issue was as follows:
Weather forecasters deal with the events of a periodic nature: seasons repeat cyclically. This world is partially predictable -- either through data-based climatological models or through theory-based Numerical Weather Prediction models. The weather forecasters are aware that they are working with a gross approximation of the underlying system and that in such an area the uncertainty must be taken into consideration. Presumably, the same awareness of uncertainty causes these experts to manifest a lower overconfidence effect than experts from the other domain. Indeed, as it was observed in the US by Murphy and Winkler (1977), meteorologists were exceptionally well calibrated in the sense that their confidence level was comparable to the actual accuracy of their predictions.Financial analysts, on the other hand, have to deal with a world which seems to be completely unpredictable, where even weak probabilistic tendencies are rarely observed. Most of the modern financial theories presume that stock prices approximately follow random walk pattern (Cootner, 1964; Samuelson, 1965; Malkiel, 1996). [There] is some important evidence that stock prices' movements deviate from randomness (Lo, 1999; Shleifer, 2000) but this has a limited meaning for the practice of forecasting. In such an area no analytical formula of forecasting can be used.
“Paradoxically,” Tyszka and Zielonka discovered, “financial analysts, having less precise knowledge than the weather forecasters about the underlying system, can be more self-assured.” Furthermore:
...the differences observed between these two groups of experts can also be accounted for by motivational factors. There are perhaps, some features of these two professions that make financial analysts manifest a higher level of self-assurance than the weather forecasters. We found that the financial analysts not only expressed a higher level of overconfidence in relation to the weather forecasters, but also, in contrast to the weather forecasters, they did not decrease their self-evaluation after being motivated to think about reasons why a forecast might have failed. Thus, the financial analysts behaved as if they had to demonstrate the ability of a perfect forecast of the events in question. Professor Raymond Dacey from Idaho University suggested that this mechanism can pertain to the clients. Unless there are severe storms in the area (hurricanes, tornadoes, possible floods), most people who listen to weather forecasts are happy if the forecast is not hopelessly inaccurate. People who listen to financial analysts (i.e., investors) are very unhappy when the forecasts are only slightly inaccurate, i.e., when the reality is slightly below their expectations. Therefore, in order not to lose their clients, financial analysts are very sensitive about their reputation and better skilled than weather forecasters in formulating excuses for their errors.
In an interview with Minyanville, Dacey said that the “Overconfidence Effect” tends to lead to the “Disposition Effect” -- a concept first explored by Hersh Shefrin, the Mario Belotti Chair in the Department of Finance at Santa Clara University's Leavey School of Business and a pioneer in the field of behavioral finance, and Meir Statman, the Glenn Klimek Professor of Finance at Leavey. Simply put, the “Disposition Effect” has to do with risk attitude and what Shefrin and Statman colloquially term “get-evenitis” -- an aversion to loss realization. “If you have a winner,” Dacey explained, “you become risk averse. If you have a loser, in the realm of losses, you are risk seeking. That difference in curvature in asset pricing is what makes the difference.” Shefrin and Statman wrote:
First, we place this behavior pattern into a wider theoretical framework concerning a general disposition to sell winners too early and hold losers too long. This framework includes other elements, namely mental accounting, regret aversion, self-control, and tax considerations. Significantly, we argue that the tendency to concentrate loss realizations in December is not normatively based; however, it is consistent with our descriptive theory. Second, we discuss evidence which suggests that this disposition shows up in real-world financial markets, not just in contrived laboratory experiments. In particular, we find that tax considerations alone cannot explain the observed patterns of loss and gain realization, and that the patterns are consistent with a combined effect of tax considerations and a disposition to sell winners and ride losers.
They continued:
While this paper has focused upon stocks and mutual funds, the general tendency to treat sunk costs as relevant has much wider application. For example, both corporate managers and shareholders are well aware of a tendency “to throw good money after bad” by continuing to operate losing ventures in the hope that a recovery will somehow take place. The case of Lockheed’s (LMT) decision to terminate its well-known L-1011 white elephant was greeted with joy by the investment community. The price of Lockheed stock jumped 18% in the day following the formal announcement of cancellation. Other examples abound.
An assessment of these phenomena as a whole by independent trader Jeff Macke makes the case that human emotion has simply not developed as quickly as the world in which we live. Using air travel as his first example, Macke rhetorically asked why some might be afraid to fly on one of the major carriers -- American Airlines (AMR), Delta (DAL), and so forth. “They take in ‘proof’ that air travel is unsafe by pointing to the occasional crash,” he told Minyanville, “while rejecting contrary evidence -- people are statistically far more likely to die driving than flying.” Extending the thought, Macke said, “People are still short the banks: Citigroup (C), Bank of America (BAC), et al. The question is, what catalyst, exactly, are they waiting for? I mean, they all almost died, but got saved by the government. You can argue on the margins and over the next 10% or even 20%, but the 'banks are houses of cards’ trade is over." “More currently,” he said, “I wouldn’t buy or sell BP (BP) because, rather obviously, I’m pretty convinced the company is run by idiots. The stock is down 50% in the two months or so I’ve been saying that Tony Hayward and his company are evil. My emotion on that point makes it unlikely, or far more unlikely, that I could be expected to interpret new information about BP correctly.” Essentially, financial prognostication -- with exceptions, of course -- boils down to a cartoon by Zach Weiner of the website Saturday Morning Breakfast Cereal: Somebody get this guy a job at Harvard... stat.
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