An old Floor Traders saying: " You'r good just as your last trade".....

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An old Floor Traders saying: " You'r just as good  as your last trade"..... 

KEY: Noteworthy the role and  relevance  of  HINDSIGHT for a professional trader. 
Such a "quality" could be a Trader  best hedge as well as the worst enemy .
It should  be  counterbalanced by a cognitive process of  self de-sensitivitisation from the overconfidence  as result of positives trades. (BookofLannes)


All rights reserved to the writer Alessandro Innocenti

We do not own any rights on this abstract

Courtesy of : BE FIN LAB

THE EFFECT OF OVERCONFIDENCE IN PROFESSIONAL FINANCIAL TRADERS
from Alessandro Innocenti
Abstract. 


The main purpose of the research is to analyze how overconfidence affects information collecting and trading of professional financial traders in a controlled experimental environment. 


The key project hypothesis is that additional information does not necessarily yield higher returns because financial traders are overconfident. Professional financial traders are overwhelmed with information and extracting relevant information is a long and hard task, while trading decisions require immediate actions. Algorithmic solutions do not manage efficiently this task, because public and private information is not structured enough to be classified and processed digitally. Consequently, professional traders, who have acquired expertise in their activity, integrate information and make critical decisions by instinct, which is a highly automatized skill. Their brain integrates unconsciously a huge amount of information from the stock market and from external sources, especially when they operates at a time frame that is intraday. 



Cognitive psychology defines these mechanisms, which are not filtered by awareness or deliberate thinking, as cognitive heuristics. By quoting Goldstein and Gigerenzer (2009) “Cognitive heuristics are strategies that humans and other animals use. We call them fast because they involve relatively little estimation and frugal because they ignore information. A heuristic is not either good or bad per se. Its performance is dictated by features of the information environment, such as low predictability, or high cue redundancy. The study of ecological rationality is the study of how information environments cause heuristics to succeed or fail.” Thus, the suitability of a specific heuristic depends on environmental conditions. To decide which heuristic fits for each situation traders rely on their own experience, as mediated by personality traits. Different personality traits affect distinct components of trading behavior, and so trading performance. 
Witteloostuijn and Meuhlfeld (2008) show that:

•  more relaxed types, who are more susceptible to regret, trade less frequently (i.e., a performance enhancing strategy). 
• Impatient, urgency-driven types with low sensitivity for environmental cues tend towards the disadvantageous price-taker role (accepting limit orders posted by other traders) and exhibit a lower tendency towards exploiting arbitrage opportunities. More generally, biological factors substantially influence trading performances. There is wide evidence that specific biological mechanisms such as certain hormones or certain genes determine investment choices. 
• Apicella et al. (2008) find that risk taking in an investment decision is positively correlated with salivary testosterone levels in men. In the same investment decision task, Dreber et al. (2009) associate significant more risk taking behavior of men with the presence of the 7-repeat allele of the dopamine receptor D4 gene. 
• Pearson and Schipper (2009) show that the ratio between the length of the 2nd (index) finger and the 4th (ring) finger of the subjects' right hand (so called “digit ratio" or more precisely 2D:4D) is positively correlated with prenatal exposure to estrogen and negatively correlated to prenatal exposure to testosterone (Manning et al., 1998, Honekopp et al., 2007). On average, men have lower 2D:4D than women. 2D:4D is to a large extent genetically determined (Paul et al., 2006), but it may also be affected by the environment in utero. In any case, it is determined before birth and thus before common economic, social, and cultural factors could shape financial trading behavior. 

Overconfidence is strictly related to these biological factors and is considered a key personality trait of financial traders.

DeBondt and Thaler (1995) in an authoritative survey on behavioral finance argue that “perhaps the most robust finding in the psychology of judgment is that people are overconfident”.

Decision-makers are overconfident when they overweigh their private information relative to the public information revealed by the decisions of others. That is, in Bayesian terms, agents weigh their own information too heavily and give too little weight to the public information. In terms of information collecting, overconfident subjects do not process exhaustively all the available information but use rules of thumb to determine which pieces of information deserve to be processed.

Overconfidence may have negative effects.

• Odean (1998) show that investors with a higher degree of overconfidence choose in general more risky portfolios than those with a lower degree of overconfidence. Psychological studies show that experts are more likely to be overconfident than relatively inexperienced subjects (Heath and Tversky, 1991 and Frascara (1999). This result is confirmed by the analysis of experimental asset markets of Maciejovsky and Kirchler (2003), where the degree of overconfidence increases during the experiment.

• Also the study of Glaser et al. (2003) has somewhat similar results since in their experiments professional traders have a higher degree of overconfidence than students in the two tasks analyzed, namely trend recognition and forecasting of stock price movements.

• A rather comprehensive comparison of various measures of overconfidence between professional and lay men is reported in Glaser et al. (2004a). Again, professionals are significantly more overconfident for most of the tasks and not for any task significantly less overconfident.

• Our experiment is divided in two STEPS. STEP 1: to measure overconfidence in a set of traders. Overconfidence is modeled as overestimation of the precision of private information and it can manifest itself in the following three forms:

• miscalibration: overconfident traders, when asked to answer questions with two answer alternatives and to state the probability that their answer professional financial traders is correct, declare a probability that is higher than the proportion of correct answers.

• The investors will be asked to state upper and lower bounds of 90% confidence intervals to five questions concerning general economics and finance knowledge. too tight volatility estimates: overconfident investors, when asked for confidence intervals for the return of an index or the return or price of a stock in the future, provide intervals that are too tight, by underestimating historical volatilities. The investors will be asked to provide median as well as upper and lower bounds of 90% confidence intervals to five questions concerning stock market forecasts for the year 2010 better than average effect : overconfident people judge themselves as better than others with regard to skills or positive personality attributes, and think that they are above average.

• Investors will be asked to answer the following two questions:(1) What percentage of customers of your discount brokerage house have better skills (e.g. in the way they interpret information; general knowledge) than you at identifying stocks with above average performance in the future? (Please give a number between 0% and 100%) (2) What percentage of customers of your discount brokerage house had higher returns than you in the four-year period from January 2008 to December 2009? (Please give a number between 0% and 100%)

• STEP 2: To provide traders with appropriate information in order to study the effect of this information on their trading behavior and to correlate their behavior with the degree of overconfidence. We will present an experimental study to examine the marginal value of additional information for traders in financial markets. In a market full of overconfident people persistent mispricing may be caused by the fact some relevant pieces of public information are ignored or misused by everyone. We will also use reaction times as a proxy for time-consuming deliberative thought. To justify this proxy we adopt the Schneider-Shiffrin separation of automatic versus controlled processes (Schneider and Shiffrin 1977; Kahneman 2003; Frederick et al. 2004, Camerer et al. 2004, 2005).

• Reasoning using methods of statistical inference involves objective decision-making and controlled cognitive processing. Cognition is the outcome of slower, more deliberative processes because it draws on higher-order, complex executive functions. On the other hand, affect is non-cognitive, links directly with motivation and so operates very quickly. Cognitive processes will require more time and effort than automated emotional, affective, instinctive responses (Zajonc 1984).

• So if following the herd is a rational learning process founded upon principles of statistical inference such as Bayesian updating then it will be controlled, cognitive, effortful and time-consuming and it will be associated with longer decision times. On the contrary, being overconfident is an output of automatic processes and then it appears when people take decisions fast. This effect in augmented in intra-day trading. (done with Lorenzo Menconi and Alessandro Santoni)