The Courage of Misguided Convictions

The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, people's deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second. Modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, our deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets.We describe empirical tests of two predictions of behavioral finance that have implications for investors and investment professionals: (1) that investors tend to sell their winning stocks and hold on to their losing stocks and (2) that, as a result of overconfidence, investors trade too much.The tendency to sell winners too soon and hold losers too long is called “the disposition effect.” To test for this effect, we used account data from a large discount broker. We found that the individual investors in the data set were 50 percent more likely to sell a winning investment than a losing investment (relative to their opportunities to do so). We also found that many investors engage in tax-motivated selling, especially in December.We discuss various alternative explanations for why investors might realize their profitable investments while retaining their losing investments: the belief that current losers will outperform current winners in the future, the desire to rebalance their portfolios, and the higher transaction costs of trading at lower prices. When we controlled the data for rebalancing and for share price, however, we continued to observe the disposition effect. And the winning investments that the investors chose to sell continued in subsequent months to outperform the losers they kept. This investment behavior is difficult to justify rationally; it is pure folly in an investor's taxable account.We next discuss a simple and powerful explanation for the high levels of trading in financial markets-overconfidence. Human beings are overconfident about their abilities, their knowledge, and their future prospects. Overconfident investors trade more than rational investors and doing so lowers their expected utilities.We present evidence that the average individual investor pays an extremely large performance penalty for trading and that those investors who trade most actively earn, on average, the lowest returns. The stocks individual investors purchase do not outperform those they sell by enough to cover the costs of trading. In fact, the purchased stocks, on average, subsequently underperform those sold-even when trading is not apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk securities.Our common psychological heritage ensures that we systematically share biases. Overconfidence provides the will to act. It gives us the courage of our misguided convictions.