Overconfidence and risky investment choices

Hyungkee Baek () and David Cho ()
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Hyungkee Baek: Nova Southeastern University
David Cho: Nova Southeastern University

Economics Bulletin, 2022, vol. 42, issue 4, 2267 - 2278

Abstract: Overconfident investors tend to overestimate their chances of relative success in competitive financial markets and undervalue risk; they are more likely to pursue risky rewards from financial markets. We intend to examine the effects of overconfidence on risk-taking behaviors among the active U.S. investors. We analyze a nationally representative survey among active investors in the U.S.: the National Financial Capability Survey (NFCS). We control for survey weights and endogeneity between dependent and independent variables. Control variables include investment depth, income, trading frequency, risk tolerance, and demographic information. We find that U.S. investors overconfident in their investment knowledge are more likely to purchase securities on margin, and invest in microcap stocks, derivatives and cryptocurrencies. We improve the previous literature by examining active investors in the U.S., studying investment choices riskier than stock market participation, using a continuous measure of overconfidence based on subjective and objective investment knowledge, and correcting for endogeneity. Taking more than optimal level of risk may reduce the welfare of investors. Investors and policy makers can collaborate to control overconfidence through financial education and counseling, which will improve the objective investment literacy and reduce the subjective literacy level, respectively. We find that U.S. investors overconfident in their investment knowledge are more likely to purchase securities on margin, and invest in microcap stocks, derivatives and cryptocurrencies. We improve the previous literature by examining active investors in the U.S., studying investment choices riskier than stock market participation, using a continuous measure of overconfidence based on subjective and objective investment knowledge, and correcting for endogeneity. Taking more than optimal level of risk may reduce the welfare of investors. Investors and policy makers can collaborate to control overconfidence through financial education and counseling, which will improve the objective investment literacy and reduce the subjective literacy level, respectively.

Keywords: Overconfidence; Risky Asset; Margin; Microcaps; Derivatives; Cryptocurrency; National Financial Capability Survey (search for similar items in EconPapers)
JEL-codes: G1 (search for similar items in EconPapers)
Date: 2022-12-30
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