Investor Competence, Trading Frequency, and Home Bias
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Investor competence ties together two important puzzles in international and financial economics, the home bias problems (too little is invested outside of the home market) and the trading frequency problem (investors trade far too often). Psychological factors such as perceived competence can play an important role in explaining investor behavior. According to Heath and Tversky, the competence effect posits that peoples willingness to act on their own judgments is affected by their subjective competence. When they feel skillful or knowledgeable, they are more willing to bet on their own judgments. The paper directly measured the underlying psychological bias. They study other papers and model competence as determined by a set of investor characteristics, such as gender, education, income, and portfolio size. They find that male investors and investors with larger portfolios and more education are more likely to believe they are competent than are female investors and those with smaller portfolios and less education.
The authors argue that both trading frequency and home bias are driven by the same underlying psychological bias, namely, the competence effect. The paper makes a hypothesis. For trading frequency, investors who feel more competent tend to trade more frequently than investors who feel less competent. From the paper, overconfidence does not subsume the competence effect. Overconfidence is usually modeled as miscalibration, e.g. overestimating the precision of information about the value of a financial security. However, some studies suggest that a second aspect of overconfidence, i.e. the better-than-average effect is associated with trading frequency. This paper builds a link for between these two. Look at data, the correlation between the observed competence and competence constructed from the model is 0.34. The estimated coefficients indicate that investor competence increases with education. Investor competence also increases with the size of the investors total portfolio. Male investors are more likely to feel competent than are female investors.
For home bias, investors will be more willing to invest in foreign securities while feeling competent about understanding the benefits and risks involved in investing in foreign assets. As a result, investors are more likely to invest in international assets. The effect of competence on home bias is robust to the inclusion of optimism toward the home market in the empirical specification. Kilka and Weber find that people are more optimistic toward their home markets than they are about international markets. The home bias is driven by this optimism. The paper again starts by investigating the determinants of investor optimism toward the US market: gender, education, age, income, portfolio size, investor sentiment toward fulfilling personal investment goals, and sentiment toward the market environment in the US.
Investor Competence and