12 Overconfidence and active management Christoph Gort and Mei Wang INTRODUCTION One area of today’s behavioral finance literature deals with the phenomenon of overconfidence, which has its roots in psychology but lends itself very well to describe behavioral patterns on financial markets. This chapter reveals that investors represented by a sample of decision makers of Swiss pension funds are on average miscalibrated and prone to the better than average effect, which are both typical facets of overconfidence.1 Miscalibration generally refers to the fact that people provide very narrow confidence intervals in various estimation tasks and by doing so they overestimate the precision of their knowledge and potentially underestimate risks of being wrong. The better than average effect describes the evidence that most people believe they achieve above average performances in various fields despite lack of indication or validation for it. Both miscalibration and the better than average effect influence the decision making on financial markets as well as the managing style of financial assets. Miscalibration can affect asset allocation decisions of investors and lead to overly risky portfolios or unintentionally high exposures to risky assets because of an underestimation of financial risks. The better than average effect, on the other hand, influences the style of managing assets and can lead to a high reliance on expected benefits of very active trading strategies and an underestimation of the inevitable difficulties of maintaining a competitive edge over the market and over peers. The basic goal of this chapter is to document the...
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