When do Investors Exhibit Stronger Behavioral Biases?∗

This paper examines whether individual investors exhibit stronger behavioral biases when value ambiguity or information uncertainty is higher. Using a six year (1991 to 1996) panel of retail stock holdings and trades, I find that investors are more overconfident and exhibit stronger disposition effect when stocks are more difficult to value. Furthermore, using trading correlation as a proxy for other behavioral biases such as limited attention and representativeness, I find that those biases also get amplified when valuation is more difficult. Additionally, behavioral biases are stronger when there is greater market-wide uncertainty, as reflected by higher mean stock-level volatility and higher unemployment rate. Collectively, the results indicate that both stock-specific and market-wide uncertainty exacerbates investors’ behavioral biases. INVESTOR OVERCONFIDENCE AND THE DISPOSITION EFFECT are perhaps two of the most widely documented biases in the recent behavioral finance literature. In the context of the stock market, the extant evidence indicates that people are overconfident in their stock investment choices, where overconfidence is a function of their personal characteristics. For instance, Odean (1999) finds that individual investors either overestimate the quality of their private information or their ability to interpret that private information. Consequently, following the trade date, the stocks these investors purchase underperform the stocks they sell. Additionally, Barber and Odean (2001) show that men exhibit greater overconfidence than women, where men trade more aggressively than women but earn lower net returns. More recently, Christoffersen and Sarkissian (2004) show that managers located See Odean (1998b), Daniel, Hirshleifer, and Subrahmanyam (1998), and Hirshleifer (2001) for a review of the literature on investor overconfidence. Odean (1998a) and Feng and Seasholes (2005) review the literature on the disposition effect.