Overconfidence and Information: The Differences between Individuals and Institutions

Abstract

We study a financial market that consists of two types of investors, individual and institutional, whose overconfidence level and information-gathering ability are different. It is assumed that all investors are overconfident on their own private information and underestimate the other investor's private information, but the institutional investor is less serious on these kinds of psychological biases. Also we assume that the institutional investor is able to uncover a piece of relevant information earlier than the individual investor. Since institutions are under the control of more experienced managers and have a better information searching and analyzing system than the individual investor, the above assumptions seem to be not so restrictive. With these assumptions, this paper shows price continuation in the short run and price reversal in the long run under certain conditions.

The Individual investor's underestimation of the institutional investor's information is the driving force for the momentum in the short run. Though the mean-reversion in the long run is caused by overconfidence of both investors, the influence of more overconfident individual investors is greater. Thus both the price continuation and price reversals are more conspicuous in stocks with a higher proportion of individual investors. These propositions can be easily tested with ownership data of firms. It also explains the well-known empirical results that there is a positive correlation between institutional investor's trades and subsequent price changes and a negative correlation between individual investor's trade and subsequent price changes. As the market wide overconfidence of investors increases, the price reversal becomes more severe. Also in the stocks where investors are easily subject to the behavioral biases, for example the stocks whose future cash flows are very ambiguous, we can find a prominent price reversal.

Keywords: Overconfidence, Information, Individual, Institution, momentum, mean reversion

JEL Classification: G12, G14