Overconfidence And Risks

Overconfidence also affects risk-taking behavior. Rational investors try to maximize returns while minimizing the amount of risk taken. However, overconfident investors misinterpret the level of risk they take. After all, if you are confident that the stocks you pick will have a high return, then where is the risk? Let’s return to the overconfident Iomega

true believers.William Bronsteen posted that his entire IRA—A sum worth around $250,000—was invested in Iomega shares. Barry Brewer, another supporter and retired carpenter, invested in Iomega shares with his family to the tune of $2 million. An entire portfolio invested in the stock of one small company? A person in retirement betting the farm on one small company? Overconfidence can clearly lead to risky behavior! At the time of these postings, Iomega stock was at a splitadjusted price of about $9 a share. Over the next couple of months, Iomega skyrocketed to $22 a share and then plunged right back to $9. Over the next three years, Iomega rode a roller coaster ride to settle at around $4 a share. Did these overconfident investors get out in time? Unfortunately, psychological biases discussed lateroften inhibit you from correcting a mistake. William and Barry are extreme examples. Your overconfidence probably leads to much less dramatic risk-taking behavior. There are several measures of risk you should consider:

• Portfolio volatility—measures the degree of ups and downs the portfolio experiences. High-volatility portfolios exhibit dramatic swings in price and are indicative of under diversification.
• Beta—a variable commonly used in the investment industry to measure the riskiness of a security. It measures the degree a portfolio changes with the stock market. A beta of one indicates that the portfolio closely follows the market. A higher beta indicates that the security has higher risk and will experience more volatility than the stock market in general.
• Company size—the smaller the size of the companies in the portfolio, the higher the risk.

The series of studies by Barber and Odean show that overconfident investors take more risk. They found that single men have the highest risk portfolios followed by married men, married women, and single women. Specifically, the portfolios of single men have the highest volatility, highest beta, and include smaller companies. For the five groups of investors sorted by turnover, the high-turnover group invested in stocks of smaller firms with higher betas compared to the stocks of the low turn over group.
Read More : Overconfidence And Risks

Related Posts