IMPACT OF REPESENTATIVE, AND OVERCONFIDENCE BIASES ON PERCEIVED

MARKET EFFICIENCY

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Literature review
Many researchers have studies the cognitive biases, emotional biases and market
efficiency in different culture in different prospects, some of which are relevant to our
study. A brief review of relevant studies regarding cognitive biases and emotional biases
(representative biases and overconfidence biases) and market efficiency are discussed
below.
Market efficiency
Market efficiency is the fundamental theory of standard finance which is explained by
FAMA (1979) is that markets are efficient. Market efficiency refer to as price of security
that prevailing in the market is the reflection of all available information (Romin, 2011:
Malkiel, 2003). Aguila, (2009) says that market efficiency means the price of security
coincides with their fair value. So we can say that market which always reflects all
available information is called efficient market (FAMA, 1997; Lo, 2007).
In reality markets are not efficient because of individual biases as well as anomalies
persist in the market that produce market inefficiency (Ajmal , Mufti & Shah ,2011).the
market which less informed and not efficient shows the presence of human
element(Kishore,2012). Due to psychological biases investor make common mistake
(Baker &Nofsinger, 2002) which effect the price of security (Maheran& Muhammad,
2009)) as a result market become inefficient. When people make decision depend on
fresh information due to this reason price of security deviate from their fundamental
value and market become inefficient (jain, 2006).Shiller,(2003) says that the concept of
market efficiency is totally wrong because efficient market theory may lead to totally
incorrect interpretation of event such as “major stock market bubble”.
There many factors that affects the market efficiency such as, fundamental heuristics,
cognitive and emotional weakness, intuitive reasoning, anomalies, limited
IMPACT OF REPESENTATIVE, AND OVERCONFIDENCE BIASES ON PERCEIVED
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informationand bounded rationality. Due bounded rationality and limited information
investors can’t take such decision that cover every contingency as result market would
become inefficient (Dietrich, Linsmeier, Kleinmuntz ,&Kachelmeier , 2001). There are
two types biases such as cognitive and emotional biases which affect the market
efficiency some biases specifically representative and overconfidence biases explain
below how these biases affect the market efficiency
Representative bias
In representative bias individuals took decision according to existing information, if new
information link with the already existing then individual believes become stronger and
they took decision without further evaluation. Ritter,(2003) says that people give too
much value on recent experience and neglect their long term effect. Some people believe
that the past returns are suggestive of future returns (Chen, Kim, Nofsinger&Rui, 2007).
So representative can be define as the degree of similarity that events has with it “parent
population” ((DeBondt&Thaler, 1995). Kahneman&Tversky, (1974) says that degree to
which event agree it population is called representative. Representativeness also leads to
the so-called “sample size neglect” which occurs when people took decision based on too
few samples (Barberis&Thaler, 2003).
People used representative heuristic in uncertain situation (Tversky&Kahneman,
1974)that leads them to errors in judgment as result market become inefficient. If people
listen positive news regarding any event and took decision accordingly it is particular
types of representative heuristic (Clapp &Trafirogla, 1992).when individual investors
used heuristic their mental effort reduced in decision making and they make incorrect
decision as result market become in efficient. Investors become over optimistic or over
pessimism because of past gain or losses as result price of stocks deviate from their fair
value and market became inefficient (Chong, Ahmad & Ali, 2011). The belief that a
small sample can resemble the parent population from which it is drawn is known as the
“law of small numbers” (Rabin, 2002; Statman, 1999) and they make incorrect decision
as result market become inefficient.
IMPACT OF REPESENTATIVE, AND OVERCONFIDENCE BIASES ON PERCEIVED
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So Representative bias directly or indirectly has effect on trading behaviors in the stock
market such as over-reaction and under-reaction of stocks. So we can say that
representative bias have significant impact on market efficiency.
Overconfidence bias
The overconfidence bias is a major finding in research that influences the individual
decision making process. De bondt and thaler (1995), state that perhaps the strongest
finding in the psychology of judgment is that people are overconfident. Studies show the
overconfidence as a cause of various outcomes. For example, overconfidence is one
obvious factor that leads to high rates of entrepreneurial entry, and such entrepreneurs
failed most frequently (Camerer and Lovallo, 1999). Malmendier and Tate (2005),
conducted a study and concluded that overconfidence leads to high rates of mergers and
acquisitions while such decisions often fail. Also Roll (1986), showed that just as
overconfidence among individuals investors may lead to excessive trading so
overconfidence among managers may lead to excessive takeover activity. Howard (1983)
and Johnson (2004), identified overconfidence among one of factors that may cause a war.
At last, Plous (1993), said that in judgment and decision making overconfidence is more
prevalent and more terrible. Schrand and Zechman (2011), clearly stated that
overconfident managers have high expectations and when these expectations no longer
meet they are more likely to engage in fraud. Overconfidence bias can be measured in
three ways or we can say that it has three facets. The first one, is overestimation defined
as overstating one’s own ability (Soll, 2007). The second is over placement identified by
Larrick, Burson, and Soll (2007). It is when people think of themselves as better than
others. The third one is overprecision, which is excessive certainty regarding the accuracy
of one’s beliefs (Barber and Odean, 2000, 2001) and (Odean, 1999).
Scores of studies have been conducted on the impact of overconfidence bias and market
efficiency. Overconfidence is the behavioral phenomenon where investors tend to
overestimate their own capabilities and investors perceive themselves as skillful.
Excessive trading is in stock market often caused by investor’s overconfidence.
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Overconfident investors are deemed to cause excessive trading in the market, and also
expose themselves to high risk. Studies show that excessive trading and exposure to high
risk can be used as proxies for overconfidence (Barber and odean, 2000, 2001). Also
Debondt and thaler (1995) and Statman, Thorley &Vorkink (2006) considered the
proposition that overconfident investors in the market are engage in excessive trading and
thus disturbing market efficiency. Odean (1998), examined overconfidence and its
reaction to private signals and concluded that as a consequence there created excess
volatility and negative return autocorrelation. In a recent study by Shah, Raza and
Khrshid (2012), found a positive impact of overconfidence bias on perceived market
efficiency.
As in the above literature contrasting views can be found about overconfidence and its
impact on perceived market efficiency. Most of these studies show a negative impact of
overconfidence on market efficiency. However it can also be found that when people
claim that they are above average, it may be true in certain cases. As Griffin and Tversky
(1992), state that experts tend to be more overconfident than relatively inexperienced
ones. This study is an effort to find out if there are any positive or favorable impacts of
overconfidence bias stemming from self-attribution bias on perceived market efficiency.








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MARKET EFFICIENCY

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