Earlier this month the paper Anxiety, Overconfidence, and Excessive Risk Taking by Thomas M. Eisenbach and Martin C. Schmalz was published by the Federal Reserve Bank of New York Staff Reports. The article attempts to understand why investors are inherently overconfident. It is the "systematic underestimation of risk" that the authors seek to understand. Specifically, they want to know how the market can be in balance or efficient when these distortions in belief exist. Ultimately, the authors blame the delusion created by the investor on the "Ostrich Effect", the tendency for the investor to reject unbiased information, and cocaine.
The authors begin by seeking out the source of overconfidence, anxiety and forgetfulness within the investor's decision framework.
We show that dynamically inconsistent preferences with respect to risk - which we call "anxiety-prone" - when combined with a possibility to forget can generate overconfidence. We assume that the agent exhibits higher risk aversion for imminent than for distant risks, i.e. horizon-dependent risk aversion. - Eisenbach and Schmalz, 2014
This is where it gets a little slippery. The authors suggest that the average investor convinces themselves that higher risks don't exist in the future, which allows them to take higher risks in the present. "A sophisticated, self-aware decision maker", however, "may search for commitment devices that constrain the future self's action space to make the chosen actions more compatible with current preferences".
One example of a commitment device may be a bond. Without these "devices", the authors suggest, the "present self" can distort the truth about future risks.
If the present self can conceal information about risks from the future self, the latter will underestimate such risks and therefore take higher risks than it otherwise would, thus alleviating the inconsistency between the present self's preferences and the future self's actions. This is true even if the future self understands the structure of this game perfectly and tries to "undo" the belief distortion in a fully Bayesian way.
Much of the paper is spent reviewing literature supporting the assumption that the allusion of time can affect risk-taking behavior. Specifically, it "generates overconfidence". Without this assumption, the theory of distortion doesn't hold.
Also critical to the theory is an explanation as to how the investor is supporting or creating this delusion. Aren't they getting the same information as everyone else? To this question, the authors provide the following explanation:
... given a preference for a biased posterior, an anxiety-prone agent will attempt to implement information and communication systems that render her misinformed about risks.
In other words, an investor may choose to get all their investment advice from a church group and co-workers. They may listen to radio or television programming geared toward excessive risk-taking. They may even select a financial adviser with a "unique" gift for mitigating the true nature of risks. The authors cite a paper by Karlsson et al. published in 2009 that finds investors look up portfolio performance less often after receiving a signal about increased risks - a behavior known quite fittingly as the "Ostrich Effect". The conclusion was that retail investors have little interest in unbiased advice.
Another study blames the delusion on drugs, citing a study titled "Did cocaine use by bankers cause the global financial crisis?" Published in The Guardian in April 2013, the paper suggests that the widespread use of cocaine by professional traders "is consistent both with strategic self-manipulation and with our observations about cross-sectional overconfidence across environments". It also suggests that drug and alcohol use may lead to forgetting, if not ignoring, the negative signals of the past.
What's the conclusion? The selective process of forgetting about or denying the existence of risk is used as a tool by the average investor to accomplish self-delusion, but what's the application? The authors plan to connect this model to asset pricing models in future research. Until then, the effect on prices is being played out every day.
What's the lesson for the average investor? Find investment vehicles that can help "lock in" a particular action over a given time period, regardless of how your views ebb and flow with risk cycles.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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