Overconfident investors and probability misjudgments

This paper explores systematic distortions of subjective probabilities by overconfident investors. In agreement with many non-expected utility theories, our devised setup acknowledges nonlinear weighting of physical probabilities by both rational and overconfident investors. Overconfidence – assumed to be higher after a history of gains and lower after a history of losses – changes these probability transformations. Using US asset price data, overconfident investors are found to be more optimistic than rational investors about future prospects.