Investor overconfidence linked to selective memory

There is extensive academic literature on the risks faced by investors who are overconfident in their ability to beat the market. They tend to trade more frequently, even if they are losing money doing so. They borrow too much and do not diversify their holdings. When the market turns suddenly, they tend to overreact. Yet despite all that evidence, there is no hard data on what makes investors overconfident in the first place.

At the cost of being wrong, you would think that people who risk money on stocks would learn from their past mistakes. But a new study suggests that our memory’s tendency to take on an optimistic past gets in the way, as people inflate their gains and forget about their losses.

Selective memory

The lack of real-world data is a bit surprising, considering there are several reasons to suspect that happy nostalgia might be involved here. Previous research shows that college students remember that their grades are better than they really were. Other research shows that people quickly forget their true cholesterol levels and remember that tests indicate they are healthier.

The two researchers behind the new work, Daniel Walters and Philip Fernbach, suggest that two processes could be involved in building a happy nostalgia about the performance of past investments. The first is what they call distortion, which can be thought of as retroactive optimism. People think their previous operations did better than they really did. The second process involved is selective forgetting, where operations that went wrong are not remembered at all.

To see if they were really at stake, the team did a couple of experiments in which they recruited people who had invested in the last year. They asked these investors to recall how it went. These memories were then compared to actual performance based on financial records. Before the record check, participants were also asked if they intended to trade again in the near future and if they expected their holdings to outperform the overall market.

Commercial

The differences between memory and reality were not dramatic, but they were consistent. When asked to recall an operation, the average person in an experiment reported that it produced a 44 percent profit; reality showed that it was 40 percent. When asked for a second, the difference was even greater: 41 percent in memory, 34 percent in reality. In another experiment, participants were asked to write down their 10 most important operations from the past year. People tended to forget to list losses about 40 percent of the time, while gains only slipped from memory 30 percent of the time.

In all cases, faulty memories tended to be related to increased interest in future operations, along with increased optimism about the ability to beat the market in the future.

Memory as a warning

To track this possible connection between memory and overconfidence, the researchers took memory out of the equation. They simply asked people to look up the two most important transactions they made in the last year, which should make them go through all of their recent transactions. A control group was asked to look for something irrelevant. All of these investors were asked the same questions about confidence in returns and intention to invest.

Seeing their actual performance tended to inject a note of caution, lowering investors’ expectation of future returns and abandoning their intention to trade in the near future compared to the control group.

Walters and Fernbach are clearly aware that there is more to overconfidence than selective memory; They point out, for example, that at least some of these results could be explained simply by people wanting to appear successful and confident. And some of these other factors could play a bigger role outside of the context of a research experiment. Still, there seems to be a real effect here, and selectively optimistic memory has been seen in other areas of human behavior.

In fact, in many situations, people are advised not to obsess over poor past performance. If you search for the phrase “don’t dwell on your mistakes,” you’ll find a large collection of pages advising you to do so, along with a large collection of self-help slogan images. A variant of the idea:be a gold fish“It even became a popular television show.” Maybe it’s time to put an asterisk to alert people that it may not apply to investment.

PNAS, 2021. DOI: 10.1073 / pnas.2026680118 (About DOIs).

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