Behavioral Biases Of Investment Advisors: The Effect Of OverconfidenceVW Staff
Department of Accounting and Finance
HELSINKI SCHOOL OF ECONOMICS
Investment advisors are professionals who assist their clients in financial decision making issues such as investing, insurance, borrowing, taxation and retirement planning. Thus investment advisors have a great impact on their clients? decisions. The advices and recommendations investment advisors give to their clients are naturally affected by the beliefs and conceptions they possess. Biases in these beliefs and conceptions can strongly affect the decision making of the clients and thus it is important to study investment advisors? behavioral biases.
Behavioral Biases: Background and Motivation
Previous literature shows that psychological factors have a substantial effect on people?s decision making. Tversky and Kahneman (1974) present that people rely on a limited number of heuristic principles which in general are quite useful, but sometimes lead to severe and systematic biases. This study focuses to examine three such behavioral biases; hindsight bias, overconfidence and self-attribution bias.
Behavioral Biases: Hindsight Bias
Hindsight bias refers to a tendency to perceive own performance better than it actually is, after learning the realization. Biais and Weber (2008) find that for hindsight biased agents the expost recollection of the initial belief will be closer to the realization than the true ex-ante expectation. According to Buksar and Conolly (1988) hindsight bias hinders learning from past experience. In a similar vein Biais and Weber (2008) present that hindsight biased agents also fail to remember how ignorant they were before observing outcomes and answers This leads agents to underestimate volatility, which again results in inefficient portfolio choice and poor risk management. One explanation of hindsight bias is the availability heuristic: the event that did occur is more salient in one’s mind than the possible outcomes that did not.
Behavioral Biases: Overconfidence
Overconfidence refers to the habit of overestimating own ability to perform in given tasks. People tend to be overconfident about own capabilities and level of knowledge. Overconfidence has several forms, such as ?better than average?, ?optimism bias? and ?setting too narrow confidence limits?. According to Barber and Odean (2000) overconfidence causes excess trading which can be risky to financial well being.
Behavioral Biases: Self-attribution
Self-attribution bias refers to a tendency to overestimate the degree to which people are responsible for their own success. Hastorf, Schneider, and Polifka (1970) write, “We are prone to attribute success to our own dispositions and failure to external forces?. In a similar vein, Gervais and Odean (2001) find that success of traders leads to increased overconfidence. When a trader is successful, he attributes too much of his success to his own ability and revises his beliefs about his ability upward too much, which increases overconfidence.
However, the exposure to behavioral biases is not homogenous. Certain factors are reported to explain the level of exposure. Lewellen, Lease and Schlarbaum (1977) find that men have stronger tendency to overconfident behavior than woman have. Korniotis and Kumar (2007) show that overconfidence decreases with age. Kaustia, Alho, and Puttonen (2008) find that expertise reduces the degree of anchoring bias. Frederick (2005) presents that people with higher cognitive abilities make more optimal decisions. This study uses a rational-experiential test by Epstein et al (1996) to characterize individual cognitive ability and thinking style. The effect of these psychological information processing styles in behavioral biases is studied.
Behavioral Biases: Research Questions
The fact that investment advisers are commonly used when it comes to saving and investing raises the question if their behavior is less exposed to behavioral biases than the behavior of their potential customers?. Investment advisors have a great impact on the decisions of their customers and if their judgment is biased, it will affect the way their customers act on financial markets (see e.g. Bluethgen et al., 2007). Irrational decision making can lead to e.g. suboptimal asset allocation and thus poor investment results.
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