Evidence of the overconfidence bias in the Egyptian stock market in different market states

Traditional finance theories fail to explain several anomalies observed in security markets. High levels of market turnover are among the most challenging market puzzles that have been documented in many security markets. Several studies assert the correlation between past market return and current market turnover. Behavioral finance theories assume that overconfidence bias is the reason behind this relation. Hence, this paper aims to study the impact of overconfidence – a behavioral bias stemming from the second building block of behavioral finance “cognitive psychology” and affecting traders’ beliefs and thereby their trading behavior in form of excessive trading. DeBondt and Tahler (1995). The study tests the overconfidence bias in the Egyptian Stock market during the period from 2002 till 2012 on the aggregate market level trough examining the relation between market returns and market turnover in different market states, seeking to document or deny whether overconfidence bias encourages investors to trade or not . The whole period is divided into four sub periods; two tranquil upward trending (2005-2005) and (2005-2008) and two volatile and down ward trending (financial crisis 2008-2010) and the (Egyptian Revolution Period 2010-2012) A quantitative research using secondary data and applying time series statistical techniques is designed. The research is following Statman et al. (2006) methodology. Time series analysis, which is based on four statistical techniques; mainly Vector Auto Regression, Optimal Lag Selection, Impulse Response Function and Granger Causality Tests are being used. Market Turnover ratios are used as proxies for overconfidence. The research finds a significant impact of past market return on current turnover in lag1, then turns negative in lag 2, and returns back positive in lag3, then remains positive and significant until lag5. This is in line with the overconfidence and self-attribution theory of Denial et al. (1997). Market States are found to be strongly affecting the trading activity within the Egyptian Stock Market, especially in an upward trending market. Trading activity is triggered by investors’ overconfidence when the Egyptian Stock Market is upward trending. There is also a positive significant impact of market gains on Market turnover in subsequent periods. Introduction According to the traditional finance theory, a market is efficient when a large number of rational investors act to maximize their profits in the direction of individual securities (Fama1960). In general, standard finance theories are designed to provide an elegant mathematical explanation that oversimplifies the reality. Nevertheless, some puzzles found on the financial markets, which previously could not be solved using these traditional finance theories are accounted for once the field of behavioral finance was assumed (Shleifer 2000). The Business and Management Review, Volume 6 Number 4 August 2015 3rd International Academic Conference in Paris (IACP), 10-11th August 2015, Paris, France 179 The new paradigm of behavioral finance i.e., finance from a broader social science perspective including psychology and sociology is now the most vital research programs, and it stands in sharp contradictions with the efficient market hypotheses. Many psychological and empirical studies in finance have found that people are not always rational, and systematic cognitive biases will lead to deviations from inferences drawn by classic theory. The overwhelming empirical predication of the efficient market hypotheses anticipate that prices should react quickly and correctly to the news, hence investors who receive the news late will not be able to profit from this information. Also, prices should neither overreact nor under react to information and thus no trends nor price reversals should be observed in the market. However these predictions have been strongly challenged. One of the main observed puzzles is high trading volume which has been found in several developed financial markets. Statman et al (2006); Chuang and Lee (2006). The New York Exchange (NYSE) for example recorded an average monthly turnover in 2010 of approximately 100% . High trading volume has been considered “the single most embarrassing fact to the standard finance paradigm” (DeBondt and Thaler 1994). Since the basic paradigm in classic finance cannot explain the excessive trading volume in financial markets, behavioral finance theorieshave been applied to enable better understanding of financial market and present theories that deviate from the assumption of rational agents. Behavioral finance studies assume that the reason behind excessive trading is investors’ overconfidence bias. DeBondt and Thaler (1995) states that “perhaps the most robust finding in the psychology of judgment is that people are overconfident. ” Overconfidence is a cognitive bias. It is the outcome of heuristic simplification (i.e., self-deception). It occurs when people tend to think that they are better than they really are (Trivers 1991). The psychology and behavioral science literature characterize people that behave as if they have more ability than they actually possess as being overconfident (Lichtenstein et al., 1982; Yates, 1990 and Goodie and Foster, 2004). Investors who attribute past success to their skill and past failure to bad luck are likely to be overconfident. An overconfident investor will seek to utilize his perceived superior ability to obtain large returns. Accordingly, overconfidence is characteristic of people, not of markets. (Odean 1998a) As markets behavior is nothing more than aggregating the behavior of all market players, overconfidence bias will accordingly influence the behavioral ofthe overall Stock Market in return.Many scholars have tested the overconfidence bias theory in the finance literature. In Daniel et al. (1998), the author refers to overconfidence as being a result of biased self-attribution with regard to past investment outcomes. They argue that overconfidence implies over-reaction to private information and under-reaction to public signals and thus leads to market mispricing. Later, in Gevias and Odean (2001), the author improves the theory that some investors tend to exaggerate their own ability and ignore the fact that they are in a bull market. In Statman et al. (2006), Statman conducts empirical research regarding the impact of overconfidence on trading volume in the US market. Given that the level of overconfidence changes with market return, they use market return to measure the degree of overconfidence. They find a significantly positive relationship between market-wide turnover and lagged market returns and view it as evidence of overconfidence. Also, Glaser and Weber (2007) document that investors with higher degrees of confidence tend to operate more in the German Stock Market, which is in line with Statman et al.’s (2006) finding. According to Morgan Stanley,the Egyptian Stock Market is one of the best emerging financial markets. In the last ten years, it has been considered the fourth highest growing market in all emerging markets with a growth rate of 19%. Thus, it deserves more attention and The Business and Management Review, Volume 6 Number 4 August 2015 3rd International Academic Conference in Paris (IACP), 10-11th August 2015, Paris, France 180 investigation Ansary (2013). Also, recent studies have clearly proved the inefficiency of the Egyptian Stock Market and that it is characterized by noise and speculativetrading behavior. (Omran 2007 and Ansary2012) Therefore, the overall aim of this research is to apply behavioral finance concepts to better explain the trading behavior within the Egyptian StockMarket. The study will try to advance an understanding of the physiological reasons that influence the relation between market return and the overall market turnover. More precisely, it will investigate the extent to which market return trigger inventors overconfidence and thereby affects the overall market turnover level. In other words, the research will examine the overconfidence hypothesis within the Egyptian Stock Market. The study tests the overconfidence bias in the Egyptian Stock market during the period from 2002 till 2012 on the aggregate market level trough examining the relation between market returns and market turnover in different market states, seeking to document or deny whether overconfidence bias encourages investors to trade or not . The whole period is divided into four sub periods; two tranquil upward trending (2005-2005) and (2005-2008) and two volatile and down ward trending (financial crisis 2008-2010) and the (Egyptian Revolution Period 2010-2012) Research objectives Hence, the main research objectives are:  Investigating the relation between past markets’ return and current market turnover in volume and value.  Discovering whether the Egyptian market and its investors are prone to the overconfidence bias  Testing the variations in the turnover in volume and value resulting from different market status. Literature Review Examining the behavior of financial markets and its’ players is of great interest and importance to most finance scholars. Several traditional finance theories have been introduced seeking to simulate the mechanism of both the markets and its investors from a normative and rational perspective. Statman (1999) mentions “Standard finance is the body of knowledge built on pillars of the arbitrage principles of Miller and Modigliani, the portfolio principles of Markowitz, the capital assets pricing theory of Sharpe, Lintner, and the optionpricing theory of and Black, Scholes, and Merton. ” The Efficient Market Hypothesis (EMH) that has emerged during the 1970s from the doctoral dissertation of Eugena Fama, is a further continuity of the rationality stream governing the traditional finance field. According to the theory, investors think and behave rationally when buying and se