Returns and Investor Behavior in Taiwan: Does Overconfidence Explain this Relationship?

This paper examines whether overconfidence can explain the relationship between performance and behavior of investors in Taiwan. Different from prior research that used a specific sample of individuals trading records, this work focuses on aggregate investor behavior to know whether overconfidence is a market-wide phenomenon. It is found that overconfident investors will trade more aggressively, and the excessive trading of overconfident investors results in the observed excessive market volatility. However, overconfidence effect exists only following bull markets. After a period of stock gains, overconfident traders tend to title their investment toward smaller-cap and growth stocks, consistent with the prediction of overconfident hypothesis that as investors become overconfident, they underestimate risk and thereby trade in riskier stocks.