Don’t Confuse Brains with a Bull Market: Attribution Bias, Market Condition, and Trading Behavior of Individual Investors*

Theory predicts that attribution bias creates overconfident traders and thus causes excessive trading in the market. This paper tests this prediction by comparing the trading behavior of individual investors in different market conditions. In a bull market, investors suffer more from attribution bias and therefore should be more overconfident and trade more excessively. Using the trading records of Chinese individual investors from January 2005 to November 2008, we find that individual investors trade more excessively in a bull market than in a bear market, where excessive trading is measured following Odean (1999) and Barber and Odean (2001). Specifically, we find that in the bull market the securities bought by individual investors significantly underperform those sold in the subsequent periods of one and three months. In the bear market, however, individual investors do not make the similar suboptimal trading decisions as they do in the bull market. In addition, the poor trading decisions made in the bull market are due to poor security selection, and not due to poor market timing. Furthermore, we demonstrate that individual investors turn their portfolios more frequently and their performance measured by market abnormal returns is significantly worse in the bull market than in the bear market. Overall, these results provide strong evidence that attribution bias creates overconfident traders and thus causes excessive trading in the market.