People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.

I test the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. For taxable investments, it is suboptimal and leads to lower after-tax returns. Tax-motivated selling is most evident in December.

We develop a multiperiod market model describing both the process by which traders learn about their ability and how a bias in this learning can create overconfident traders. A trader in our model initially does not know his own ability. He infers this ability from his successes and failures. In assessing his ability the trader takes too much credit for his successes. This leads him to become overconfident. A trader's expected level of over-confidence increases in the early stages of his career. Then, with more experience, he comes to better recognize his own ability. The patterns in trading volume, expected profits, price volatility, and expected prices resulting from this endogenous overconfidence are analyzed.

[We test and confirm the hypothesis that individual investors are net buyers of attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one-day returns. Attention-driven buying results from the difficulty that investors have searching the thousands of stocks they can potentially buy. Individual investors do not face the same search problem when selling because they tend to sell only stocks they already own. We hypothesize that many investors consider purchasing only stocks that have first caught their attention. Thus, preferences determine choices after attention has determined the choice set.]

We analyze 1,607 investors who switched from phone-based to online trading during the 1990s. Those who switch to online trading perform well prior to going online, beating the market by more than 2% annually. After going online, they trade more actively, more speculatively, and less profitably than before-lagging the market by more than 3% annually. Reductions in market frictions (lower trading costs, improved execution speed, and greater ease of access) do not explain these findings. Overconfidence-augmented by self-attribution bias and the illusions of knowledge and control-can explain the increase in trading and reduction in performance of online investors.

Trading volume on the world’s markets seems high, perhaps higher than can be explained by models of rational markets. For example, the average annual turnover rate on the New York Stock Exchange (NYSE) is currently greater than 75 percent and the daily trading volume of foreign-exchange transactions in all currencies (including forwards, swaps, and spot transactions) is roughly one-quarter of the total annual world trade and investment flow (James Dow and Gary Gorton, 1997). While this level of trade may seem disproportionate to investors’ rebalancing and hedging needs, we lack economic models that predict what trading volume in these market should be. In theoretical models trading volume ranges from zero (e.g., in rational expectation models without noise) to infinite (e.g., when traders dynamically hedge in the absence of trading costs). But without a model which predicts what trading volume should be in real markets, it is difficult to test whether observed volume is too high. If trading is excessive for a market as a whole, then it must be excessive for some groups of participants in that market. This paper demonstrates that the trading volume of a particular class of investors, those with discount brokerage accounts, is excessive. Alexandros V. Benos (1998) and Odean (1998a) propose that, due to their overconfidence, investors will trade too much. This paper tests that hypothesis. The trading of discount brokerage customers is good for testing the overconfidence theory of excessive trading because this trading is not complicated by agency relationships. Excessive trading in retail brokerage accounts could, on the other hand, result from either investors’ overconfidence or from brokers churning accounts to generate commissions. Excessive institutional trading, too, might result from overconfidence or from agency relationships. Dow and Gorton (1997) develop a model in which money managers, who would otherwise not trade, do so to signal to their employers that they are earning their fees and are not “simply doing nothing.” While the overconfidence theory is tested here with respect to a particular group of traders, other groups of traders are likely to be overconfident as well. Psychologists show that most people generally are overconfident about their abilities (Jerome D. Frank, 1935) and about the precision of their knowledge (Baruch Fischhoff et al., 1977; Marc Alpert and Howard Raiffa, 1982; Sarah Lichtenstein et al., 1982). Security selection can be a difficult task, and it is precisely in such difficult tasks that people exhibit the greatest overconfidence. Dale Griffin and Amos Tversky (1992) write that when predictability is very low, as in securities markets, experts may even be more prone to overconfidence than novices. It has been suggested that investors who behave nonrationally will not do well in financial markets and will not continue to trade in them. There are reasons, though, why we might expect those who actively trade in * Graduate School of Management, University of California, Davis, CA 95616. This paper is based on my dissertation at the University of California-Berkeley. I would like to thank Brad Barber, Hayne Leland, David Modest, Richard Roll, Mark Rubinstein, Paul Ruud, Richard Thaler, Brett Trueman, and the participants at the Berkeley Program in Finance, the National Bureau of Economic Research behavioral finance meetings, the Conference on Household Financial Decision Making and Asset Allocation at The Wharton School, the Western Finance Association meetings, and the Russell Sage Institute for Behavioral Economics, and seminar participants at the University of California-Berkeley, the Yale School of Management, the University of California-Davis, the University of Southern California, the University of North Carolina, Duke University, the University of Pennsylvania, Stanford University, the University of Oregon, Harvard University, the Massachusetts Institute of Technology, Dartmouth College, the University of Chicago, the University of British Columbia, Northwestern University, the University of Texas, UCLA, the University of Michigan, and Columbia University for helpful comments. I would also like to thank Jeremy Evnine and especially the discount brokerage house which provided the data necessary for this study. Financial support from the Nasdaq Foundation and the American Association of Individual Investors is gratefully acknowledged. 1 The NYSE website (http://www.nyse.com/public/ market/2c/2cix.htm) reports 1998 turnover at 76 percent.

When assessing a fund manager's skill, sophisticated investors will consider all factors (priced and unpriced) that explain cross-sectional variation in fund performance. We investigate which factors investors attend to by analyzing mutual fund flows as a function of recent returns decomposed into alpha and factor-related returns. Surprisingly, investors attend most to market risk (beta) when evaluating funds and treat returns attributable to size, value, momentum, and industry factors as alpha. Using proxies for investor sophistication (wealth, distribution channels, and periods of high investor sentiment), we find that more sophisticated investors use more sophisticated benchmarks when evaluating fund performance.

[We study the trading of individual investors using transaction data and identifying buyer- or seller-initiated trades. We document four results: (1) Small trade order imbalance correlates well with order imbalance based on trades from retail brokers. (2) Individual investors herd. (3) When measured annually, small trade order imbalance forecasts future returns; stocks heavily bought underperform stocks heavily sold by 4.4 percentage points the following year. (4) Over a weekly horizon, small trade order imbalance reliably predicts returns, but in the opposite direction; stocks heavily bought one week earn strong returns the subsequent week, while stocks heavily sold earn poor returns.]

People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price‐taking traders, a strategic‐trading insider, and risk‐averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information.

ABSTRACT I test the disposition effect, the tendency of investors to hold losing investments too long and sell winning investments too soon, by analyzing trading records for 10,000 accounts at a large discount brokerage house. These investors demonstrate a strong preference for realizing winners rather than losers. Their behavior does not appear to be motivated by a desire to rebalance portfolios, or to avoid the higher trading costs of low priced stocks. Nor is it justified by subsequent portfolio performance. For taxable investments, it is suboptimal and leads to lower after‐tax returns. Tax‐motivated selling is most evident in December.