Overconfidence, financial literacy and excessive trading

This paper examines how overconfidence in financial literacy, as measured by MiFID test scores, impacts investors' trading behavior. Our theoretical model suggests that overconfident investors exhibit a higher demand for risky assets, potentially underperform compared to rational investors, and face higher transaction costs, thereby benefiting brokers. Furthermore, the impact of overconfidence intensifies with its level. We then test these propositions empirically using a unique brokerage dataset. Our findings reveal that overconfident investors engage in more frequent trading and incur higher transaction costs, with both effects increasing as overconfidence levels rise. However, we do not find evidence supporting the notion that they perform worse than rational investors. In fact, their performance tends to improve with higher levels of overconfidence. Additionally, we explore whether stress resulting from a mismatch between MiFID test scores and subjective financial literacy can mitigate the impact of overconfidence. Our data lends some support to this hypothesis.