Overconfidence Bias in International Stock Prices

Abstract

This study expands tests of the overconfidence hypothesis to international markets, where the evidence is consistent with the hypothesis that stock prices the world around are also biased by investor overconfidence. A novel aspect of the test here is combination of the overconfidence hypothesis with valuation theory. When stocks are categorized according to how quickly they are expected to grow, there is an interaction effect between earnings growth and the payoffs to contrarian and momentum strategies. Data from France, Germany, Japan, the U.K., and the U.S. show that successful investment strategies differ, depending on a stock's growth rate. A momentum strategy of buying stocks with positive earnings estimate revisions and selling stocks with negative estimate revisions is significantly more profitable in fast-growth companies, for instance, while a contrarian strategy of buying low P/E stocks and selling high P/E stocks produces greater and more consistent profits in slow-growth companies. The results suggest that traditional value-oriented managers should focus on slow-growth companies, while successful growth managers should ride winners and be willing to sell when confronted with bad news.