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Overconfidence Among Professional Investors: Evidence From Mutual Fund Managers

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Abstract

We examine overconfidence among equity mutual fund managers. While overconfidence has been extensively documented among retail investors, evidence from professional investors is scarce. Consistent with theories of overconfidence, we find that fund managers trade more after good past performance. The higher trading activity after good performance is driven by individual portfolio performance, while the market performance has no significant impact. We find no spillover effects from one good performing fund on the turnover ratios of the other funds the same manager manages, suggesting that managerial overconfidence is task-specific. Our results are not consistent with an increase in trading activity by fund managers when rational Bayesian learning has informed them about their abilities.

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... Mutual fund managers are overconfident as a result of their fund's outstanding historical performance, which demonstrates their managing skills. This results in greater trading, and among the top 10% of best-performing funds, those with low turnover can outperform those with high turnover (Puetz and Ruenzi, 2011), although such excessive trading also delivers negative results. Chow et al. (2011) andPalomino andSadrieh (2011) believe that the pattern, as mentioned above, is the outcome of self-attribution, in which managers pursue portfolio rebalancing and momentum strategies in which management fees increase after an excellent performance but do not fall after a poor performance. ...
... Sias (2004) Measures points out that the magnitude and the decomposition of the correlation in mutual fund demand could be influenced by the variation in the number of mutual funds. It examines the average "following their own trades," as well as the average "following others' trades" contributions to the correlation for each security-quarter Sias (2004) Measure Average following their own trades contribution k,t ¼ PN * k;t n¼1 ðD n;k;t − RawΔt ÞðD n;k;t−1 − RawΔ t−1 Þ N * k;t Where N * k;t is the number of managers trading security k in both quarter Average following others' trades contribution k,t (2017) Overconfidence Turnover Ratio Measure gauges the buying and selling of assets in a fund, i.e. total trading activity which may be influenced by past performance and fund flows, potentially masking the influence of overconfidence Turnover Ratio Measure TR ¼ min ðaggregated sales or aggregated purchases of securitiesÞ average 12 − months Total Net Assets of the fund Source: Puetz and Ruenzi (2011) Familiarity Bias "Geographic distance" measures the distance between two locations using the great distance circle method Geographic distance Measures TR ¼ min ðaggregated sales or aggregated purchases of securitiesÞ average 12 − months Total Net Assets of the fund Source: Fong et al. (2008) "Home state Managers" ratio provides insights into the regional composition of fund management teams "Home state Managers" ratio is the number of managers of fund from state to the total number of managers of fund during a period Source: Pool et al. (2012) (continued ) For instructions on how to order reprints of this article, please visit our website: www.emeraldgrouppublishing.com/licensing/reprints.htm Or contact us for further details: permissions@emeraldinsight.com ...
Article
Purpose The purpose of the study is to investigate, synthesize and critically evaluate empirical research findings on the behavioral traits of fund managers from 1994 to 2024. The ultimate goal is to provide a unified body of literature on three broad topics: first, fund managers' demographic and professional characteristics, such as age, gender, level of education and years of industry experience; second, fund managers' social and political connections; and third, fund managers' behavioral biases that lead to irrational investment decisions. Design/methodology/approach The relevant papers from selected journals were discovered and manually validated using the Scopus database. From 317 retrieved documents, 57 relevant articles were chosen and analyzed after the forward and backward search of the existing articles. Findings This paper presents a categorized summary of behavioral factors that have gained a foothold in influencing the behavior of fund managers in fund management research, with several studies demonstrating their significance leading to improved prediction and model precision, as this review indicates. In addition, the study summarized the contributions of prior empirical studies within the aforementioned three major categories and illustrated their consequences. Originality/value The present study contributes to the understanding of the effects of behavioral finance theories on fund managers by providing meaningful explanations of their behavioral traits based on empirical evidence and existing trends and knowledge gaps, both of which can influence the future direction of research.
... The higher-earning individuals are more overconfident and often invest heavily (Kansal & Singh, 2018). Several studies (Chuang & Susmel, 2011;Daniel & Hirshleifer, 2015;Mushinada & Veluri, 2020;Puetz & Ruenzi, 2011;Sabir et al., 2019) have used success as a base to determine investor overconfidence. Hence, we prompt the following proposition: ...
... As the investors, time and experience increase in the stock market, which generates overconfidence among investors in their decisions (Baker et al., 2019;Mishra & Metilda, 2015;Mushinada & Veluri, 2019). In this context, Puetz and Ruenzi (2011) conclude that overconfidence and past performance have a similar relationship for individual managers and management teams. Moreover, Khan et al. (2019) conclude that investors get overconfident and behave irrationally due to prior experience and limited information availability. ...
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The current study uses a systematic literature review to summarize and highlight studies on overconfidence bias in investment decision-making. More specifically, the study synthesizes the overconfidence literature highlighting the year of publication, country of the published articles, research methods, data sources, prominent theories, statistical techniques, citation analysis of the popular articles and authors and future research topics. The authors study 111 documents indexed in Scopus and/or Web of Science databases to recognize research trends regarding overconfidence bias during the last 29 years (1995–2023). The results indicate that most (61.26%) selected studies are empirical. Likewise, secondary data-based articles dominate primary ones. Additionally, the resulting factors can be classified into four themes: the construct of overconfidence bias and investments; success: a cause of overconfidence; gender and overconfidence; and the consequences of overconfidence. To the authors’ best knowledge, this is a unique article in which research outcomes of essential aspects of overconfidence are skimmed systematically.
... Following that, their performance declined. Puetz and Ruenzi (2009) found that positive past performance leads to overconfidence. Mundi and Nagpal (2020) examined the overconfidence among finance managers and its influence on predicted market return. ...
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The study aims to comprehensively examine the behavioral biases of fund managers by conducting a bibliometric analysis of research papers published during the years 2011–2022 from the Scopus database based on the keywords searched for behavioral biases of fund managers. One hundred and thirty-five articles have been chosen after careful review. This article explains the most cited articles, top authors, leading countries, prolific journals, and important keywords. This study has identified 10 different types of behavioral biases which are summarized in this article. In this review article, we only considered the journal articles excluding conference publications, editorials, and book chapters. This article is based on the existing literature on behavioral biases in investment decision-making processes. This study will be helpful for researchers and academicians to understand the impact of behavioral biases on investment decisions and to reduce it. Finally, this research will provide a roadmap for future research.
... The link between past performance, beliefs, and subsequent decision-making has been addressed in different settings. For instance, evidence suggests that past success may induce overconfidence, which can distort the decisionmaking of nonprofessional traders ( Czaja and Röder, 2020 ), professional investors ( Puetz and Ruenzi, 2011 ), sell-side financial analysts ( Hilary and Menzly, 2006 ), and even CEOs ( Billett and Qian, 2008 ;Hilary and Hsu, 2011 ). In the context of professional basketball, Bühren and Krabel (2019) suggest that players who experience success, i.e., who score an equalizer before overtime, exhibit a "sloppiness effect": Their performance during overtime is substantially worse than their usual performance, which is consistent with the explanation of player overconfidence affecting subsequent performance. ...
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Exploiting a quasi-experimental field setting, we examine whether people are outcome biased when self-evaluating their past decisions. Using data from Swiss driving license exams, we find that candidates who narrowly passed the theoretical driving exam are significantly less likely to pass the subsequent practical driving exam – which is taken several months after the theoretical exam – than those who narrowly failed. Those candidates who passed the theoretical exam on their first attempt receive more objections regarding their momentary, on-the-spot decisions in the practical exam, consistent with the idea that the underlying behavioral difference is worse preparation.
... This propensity could be explained by overconfidence bias. Consistent with this possibility, Puetz and Ruenzi (2011) find evidence of self-serving attribution bias as a cause of overconfidence. Polkovnichenko (2005) shows that investors who appear confident with the positive outcome of their strategy tend to underdiversify their portfolios. ...
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... Esta clasificación sigue utilizándose en la economía financiera, pero la segunda generación de las finanzas comportamentales (ver Statman, 2019), que se viene desarrollando en la última década, propone evitar el calificativo de racional o irracional, afirmando que los inversionistas son personas normales, seres humanos con diferentes personalidades, gustos, creencias, emociones, expectativas, necesidades, aspiraciones, formas de pensar y de actuar. Tales aspectos y, con ellos, la posibilidad de tomar decisiones de inversión subóptimas, están presentes tanto en los clientes inversionistas como en los inversionistas profesionales (Bailey, Kumar & Ng, 2011;Barberis & Thaler, 2003;Feng & Seasholes, 2005;Kaustia, Alho & Puttonen, 2008;Puertz & Ruenzi, 2011;Szyskza, 2013). ...
... They show that current trading activity in the stock market is positively correlated with past stock market returns for several months. Puetz and Ruenzi (2011) find that equity mutual fund managers trade more after good past performance, which is consistent with the theory of overconfidence. While these studies support the argument of overconfidence in the stock market, they do not address the issue of overconfidence in the options market. ...
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Investigated how often people are wrong when they are certain that they know the answer to a question. Five studies with a total of 528 paid volunteers suggest that the answer is "too often." For a variety of general-knowledge questions, Ss first chose the most likely answer and then indicated their degree of certainty that the answer they had selected was, in fact, correct. Across several different question and response formats, Ss were consistently overconfident. They had sufficient faith in their confidence judgments to be willing to stake money on their validity. The psychological bases for unwarranted certainty are discussed in terms of the inferential processes whereby knowledge is constructed from perceptions and memories. (15 ref) (PsycINFO Database Record (c) 2012 APA, all rights reserved)
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This paper studies the dynamics of investor overconfidence. Using the sum of absolute deviations from one's benchmark index (i.e., Active Share) as a proxy for confidence, we show that the average mutual fund manager tends to boost his confidence to a larger extent after receiving confirming public signals than to decrease it after disconfirming public signals. This bias is stronger among inexperienced managers and is largely absent among experienced ones. The bias also leads to poor future performance, the majority of which is driven by managers' sub-optimal portfolio choices. In dissecting managers' portfolio choices, we further document that the underperformance resulting from biased attribution is potentially due to managers' increasingly active stock picks in industries that they are less familiar with.
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Absent much theory, empirical works often rely on the following informal reasoning when looking for evidence of a mutual fund tournament: If there is a tournament, interim winners have incentives to decrease their portfolio volatility as they attempt to protect their lead, while interim losers are expected to increase their volatility so as to catch up with winners. We consider a rational model of a mutual fund tournament in the presence of short-sale constraints and find the opposite - interim winners choose more volatile portfolios in equilibrium than interim losers. Several empirical works present evidence consistent with our model, however based on the above informal argument they appear to conclude against the tournament behavior. We argue that this conclusion is unwarranted. We also demonstrate that tournament incentives lead to differences in interim performance for otherwise identical managers, and that mid-year trading volume is inversely related to mid-year stock return.
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In this paper I derive a risk-adjusted measure of portfolio performance (now known as Jensen's Alpha) that estimates how much a manager's forecasting ability contributes to the fund's returns. The measure is based on the theory of the pricing of capital assets by Sharpe (1964), Lintner (1965a) and Treynor (Undated). I apply the measure to estimate the predictive ability of 115 mutual fund managers in the period 1945-1964 - that is their ability to earn returns which are higher than those we would expect given the level of risk of each of the portfolios. The foundations of the model and the properties of the performance measure suggested here are discussed in Section II. The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses.
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We argue that managerial overconfidence can account for corporate investment distortions. Overconfident managers overestimate the returns to their investment projects and view external funds as unduly costly. Thus, they overinvest when they have abundant internal funds, but curtail investment when they require external financing. We test the overconfidence hypothesis, using panel data on personal portfolio and corporate investment decisions of Forbes 500 CEOs. We classify CEOs as overconfident if they persistently fail to reduce their personal exposure to company-specific risk. We find that investment of overconfident CEOs is significantly more responsive to cash flow, particularly in equity-dependent firms.
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This paper offers a model in which asset prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade against mispricing. In equilibrium, expected returns are linearly related to both risk and mispricing measures (e.g., fundamental/price ratios). With many securities, mispricing of idiosyncratic value components diminishes but systematic mispricing does not. The theory offers untested empirical implications about volume, volatility, fundamental/price ratios, and mean returns, and is consistent with several empirical findings. These include the ability of fundamental/price ratios and market value to forecast returns, and the domination of beta by these variables in some studies.
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This study shows that the propensity to gamble and investment decisions are correlated. At the aggregate level, individual investors prefer stocks with lottery features, and like lottery demand, the demand for lottery-type stocks increases during economic downturns. In the cross-section, socioeconomic factors that induce greater expenditure in lotteries are associated with greater investment in lottery-type stocks. Further, lottery investment levels are higher in regions with favorable lottery environments. Because lottery-type stocks underperform, gambling-related underperformance is greater among low-income investors who excessively overweight lottery-type stocks. These results indicate that state lotteries and lottery-type stocks attract very similar socioeconomic clienteles.
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Previous empirical studies of information cascades use either naturally occurring data or laboratory experiments. We combine attractive elements from each of these lines of research by observing market professionals from the Chicago Board of Trade (CBOT) in a controlled environment. Analysis of over 1,500 individual decisions suggests that CBOT professionals behave differently from our student control group. For instance, professionals are better able to discern the quality of public signals and their decisions are not affected by the domain of earnings. These results have implications for market efficiency and are important in both a positive and normative sense.
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We show that new managers who take over mutual fund portfolios sell off inherited momentum losers at higher rates than stocks in any other momentum decile, even after adjusting for concurrent trades in these stocks by continuing fund managers. This behavior is observed regardless of fund characteristics and is stronger when new managers are external hires. The tendency of continuing fund managers to hold on to losers could be consistent with either a behavior bias stemming from an inability to ignore the sunk costs associated with the stocks' past underperformance or a conscious desire to protect their careers by not admitting prior mistakes. Furthermore, we present evidence that selling off loser stocks helps improve fund performance. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
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Using a large sample of individual investor records over a nine-year period, we analyze survival rates, the disposition effect, and trading performance at the individual level to determine whether and how investors learn from their trading experience. We find evidence of two types of learning: some investors become better at trading with experience, while others stop trading after realizing that their ability is poor. A substantial part of overall learning by trading is explained by the second type. By ignoring investor attrition, the existing literature significantly overestimates how quickly investors become better at trading. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.
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The returns and stock holdings of institutional investors from 1980 to 2007 provide little evidence of stock-picking skill. Institutions as a whole closely mimic the market portfolio, with pre-cost returns that have nearly perfect correlation with the value-weighted index and an insignificant CAPM alpha of 0.08% quarterly. Institutions also show little tendency to bet on any of the main characteristics known to predict stock returns, such as book-to-market, momentum, or accruals. While particular groups of institutions have modest stock-picking skill relative to the CAPM, their performance is almost entirely explained by the book-to-market and momentum effects in returns. Further, no group holds a portfolio that deviates efficiently from the market portfolio.
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"We use data from surveys involving 300 Scandinavian financial market professionals and 213 university students to conduct three controlled experiments in which we manipulate the background information given to subjects. We find a very large anchoring effect in the students' long-term stock return expectations, that is, their estimates are influenced by an initial starting value. Professionals show a much smaller anchoring effect, but it nevertheless remains statistically and economically significant, even when we restrict the sample to more experienced professionals. We also find that the professionals are not conscious of the impact of historical returns on their expectations." Copyright (c) 2008 Financial Management Association International..
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This paper provides the first empirical test of the diversification of opinions theory and the group shift theory using real business data. Our data set covers management teams and single managers of US equity mutual funds. Our results reject the group shift theory and support the diversification of opinions theory: teams follow less extreme investment styles, their portfolios are less industry concentrated, and they are eventually less likely to achieve extreme performance outcomes. These results hold after taking into account the impact of fund and family characteristics as well as manager characteristics. Copyright 2010, Oxford University Press.
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As a group, market forecasters are overconfident in the sense that they are miscalibrated. While overconfidence is persistent, respondents do exhibit some degree of rational learning in that they widen confidence intervals after failure as much as they narrow them after success. Market experience exacerbates overconfidence, primarily through knowledge deterioration.
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We develop a two-period model of a Brown et al. [J. Finance 51 (1996) 85] mutual fund tournament in which two fund managers with unequal midyear performances compete for new cash inflows. When one of the managers is an exogenous benchmark, winning managers index and losing managers gamble. However, when both managers are active, the winning manager is more likely to gamble—expecially when the midyear performance gap is high or when stocks offer high returns and low volatility. Empirical evidence that winning managers gamble has been documented by other researchers, but it has been interpreted as evidence against the tournament model. With a dataset of weekly returns from 1984 to 1996 for 660 mutual funds, we text for other tournament effects predicted by the model. Our results suggest a role for the theory of tournaments in studies of mutual fund behavior.
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This paper examines the relation between the replacement of mutual fund managers and their prior performance. Using the growth rate in a fund's asset base and its portfolio returns as two separate measures of performance, I document an inverse relation between the probability of managerial replacement and fund performance. The sample of departing fund managers exhibits higher portfolio turnover rates and higher expenses relative to an objective-matched sample of nonreplaced fund managers. The overall evidence is consistent with the presence of well-functioning internal and external market mechanisms for mutual fund managers.
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The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and the updating of reference prices, generates predictable equilibrium prices interpretable as possessing momentum. Empirically, a variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Controlling for this variable, past returns have no predictability for the cross-section of returns.
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Does CEO overconfidence help to explain merger decisions? Overconfident CEOs over-estimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs’ personal over-investment in their company and their press portrayal. We find that the odds of making an acquisition are 65% higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (-90 basis points) is significantly more negative than for non-overconfident CEOs (-12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.
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This paper examines institutional price pressure in equity markets by studying mutual fund transactions caused by capital flows from 1980 to 2004. Funds experiencing large outflows tend to decrease existing positions, which creates price pressure in the securities held in common by distressed funds. Similarly, the tendency among funds experiencing large inflows to expand existing positions creates positive price pressure in overlapping holdings. Investors who trade against constrained mutual funds earn significant returns for providing liquidity. In addition, future flow-driven transactions are predictable, creating an incentive to front-run the anticipated forced trades by funds experiencing extreme capital flows.
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This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
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We examine the influence on managerial risk taking of incentives due to employment risk and due to compensation. Our empirical investigation of the risk taking behavior of mutual fund managers indicates that managerial risk taking crucially depends on the relative importance of these incentives. When employment risk is more important than compensation incentives, fund managers with a poor midyear performance tend to decrease risk relative to leading managers to prevent potential job loss. When employment risk is low, compensation incentives become more relevant and fund managers with a poor midyear performance increase risk to catch up with the midyear winners.
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We explore the history of mergers and acquisitions made by individual CEOs. Our study has three main findings: (1) CEOs' first deals exhibit zero announcement effects while their subsequent deals exhibit negative announcement effects; (2) While acquisition likelihood increases in the performance associated with previous acquisitions, previous positive performance does not curb the negative wealth effects associated with subsequent deals; (3) CEOs' net purchase of stock is greater preceding subsequent deals than it is for first deals. We interpret these results as consistent with self-attribution bias leading to overconfidence. We also find evidence that the market anticipates future deals based on the CEO's acquisition history and impounds such anticipation into stock prices.