short- versus long-term autocorrelations, and volatility. Section 3 examines
time variation in overconfidence, to derive implications about the signs of
short-term versus long-term return autocorrelations. Section 4 concludes by
summarizing our findings, relating our analysis to the literature on exoge-
nous noise trading, and discussing issues related to the survival of overcon-
fident traders in financial markets.
1 .Overconfidence and Biased Self-AttributionThe model we present in this chapter relies on two psychological regulari-
ties: overconfidenceand attribution bias.In their summary of the micro-
foundations of behavioral finance, DeBondt and Thaler (1995) state that
“perhaps the most robust finding in the psychology of judgment is that
people are overconfident.” Evidence of overconfidence has been found in
several contexts. Examples include psychologists, physicians and nurses,
engineers, attorneys, negotiators, entrepreneurs, managers, investment
bankers, and market professionals such as security analysts and economic
forecasters.^2 Further, some evidence suggests that experts tend to be more
overconfident than relatively inexperienced individuals (Griffin and Tver-
sky 1992). Psychological evidence also indicates that overconfidence is
more severe for diffuse tasks (e.g., making diagnoses of illnesses) that re-
quire judgment than for mechanical tasks (e.g., solving arithmetic prob-
lems); and tasks for which delayed feedback is received, as opposed to
tasks that provide immediate and conclusive outcome feedback, such as
weather forecasting or horse-racing handicapping (see Einhorn 1980).
Fundamental valuation of securities (forecasting long-termcash flows) re-
quires judgement about open-ended issues, and feedback is noisy and de-
ferred. We therefore focus on the implications of overconfidence for financial
markets.^3
Our theory assumes that investors view themselves as more able to value
securities than they actually are, so that they underestimate their forecast
error variance. This is consistent with evidence that people overestimate their
own abilities, and perceive themselves more favorably than they are viewed
by others.^4 Several experimental studies find that individuals underestimate
INVESTOR PSYCHOLOGY 465(^2) See respectively: Oskamp (1965), Christensen-Szalanski and Bushyhead (1981), Bau-
mann, Deber, and Thompson (1991), Kidd (1970), Wagenaar and Keren (1986), Neale and
Bazerman (1990), Cooper, Woo, and Dunkelberg (1988), Russo and Schoemaker (1992), Stael
von Holstein (1972), Ahlers and Lakonishok (1983), Elton, Gruber, and Gultekin (1984),
Froot and Frankel (1989), DeBondt and Thaler (1990), DeBondt (1991). See Odean (1998)
for a good summary of empirical research on overconfidence.
(^3) Odean (1998) (section 2.D) also makes a good argument for why overconfidence should
dominate in financial markets.
(^4) Greenwald (1980), Svenson (1981), Cooper, Woo, and Dunkelberg (1988), and Taylor
and Brown (1988).