The Psychology of Investing – John R. Nofsinger : [PDF Download]

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“Investing is a difficult process. It entails gathering information, analyzing it, and making a decision based on that information. However, overconfidence causes us to misinterpret the accuracy of our information and overestimate our skill in analyzing it. It occurs after we experience some success.

The selfattribution bias leads people to believe that successes are attributed to skill while failure is caused by bad luck. After some success in the market, investors may exhibit overconfident behavior. Consider the behavior of financial analysts.

Analysts publicize their predictions about the future earnings of the firms they follow. Gilles Hilary and Lior Menzly studied the predictions of analysts after the analysts have been shown a series of good earnings estimates.4 If this success causes the analysts to put excessive weight on their private information and skill, then their next predictions are likely to be less accurate than average and deviate from the other analysts.

After examining over 40,000 quarterly earnings predictions, Hilary and Menzly found that success leads to overconfidence. Analysts who perform well for a few quarters follow with predictions that are different from other analysts’ estimates and ultimately have greater errors.

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