The effect of overconfidence on stock market bubbles, velocity and volatility

Abstract

The goal of this thesis is to research and explain the relationship between overconfidence and stock market bubbles, velocity and volatility. This thesis outlines that overconfidence causes increased trading volume, excessive risk taking behavior, increased leverage taking and overpaying. Consequently, via these channels stock market bubbles are caused. Next to this, the DHS model finds that overconfidence and the resulting self-attribution bias can cause stock market bubbles while the DSSW model explains that herding leads to stock market bubbles which is behavior associated with overconfidence and is not arbitraged away by rational speculators. Therefore, a positive relation between overconfidence and stock market bubbles is hypothesized. Another theoretical finding is that overconfidence can cause increased velocity and volatility. The theoretical findings for the relationship between overconfidence and stock market bubbles, velocity and volatility are not convincingly found in the empirical tests. Using our previously described methods, there is no relationship found for overconfidence and velocity. Moreover, this thesis reports a weak positive relationship between overconfidence and stock market bubbles and overconfidence and volatility. Therefore, it can be concluded that overconfidence can at least in some situations cause stock market bubbles and increased volatility while it cannot cause increased velocity.