Doing your own homework can lead to bad grades in investing

Investors are supposed to do their homework before deciding where to put their money, but a new study from the University of Iowa suggests too much homework might be counterproductive.

The study finds that investors who do their own research and write down their predictions become so overconfident in their analysis they stick with their investment strategy even if subsequent information contradicts their original predictions.  

For some, it pays off. If your predictions are correct, you can make more money, says study co-author Tom Gruca, professor of marketing in the Tippie College of Business. But most people’s analyses will be incorrect, and their overconfidence will lead them to hold a bad investment too long instead of selling it.

Tom Gruca

“Everyone is overconfident, but most people are wrong and don’t want to change their minds,” he says.

The study examined trading patterns on the Iowa Electronic Markets’ box office prediction market, where UI students bought and sold contracts as part of a class assignment based on their predictions of the four-week box office returns for four movies. Before trading began, each student trader researched a movie, then wrote a report with detailed analysis of the projected box office performance. The study included markets for the 1998 releases of I Still Know What You Did Last Summer and Enemy of the State and the 2000 releases of How the Grinch Stole Christmas and The Sixth Day.

The students’ trading patterns once the markets opened resembled those of overconfident investors, Gruca says. For instance, overconfident traders tend to trade more frequently, and that was also true for these markets, where the average number of trades per trader was 43 in 1998 and 24 in 2000.

More revealing was the timing of transactions, which showed that traders did most of their buying and selling based on their own information, ignoring publicly available information. In three of the four markets, more than half of all trades were made before the movie even opened and any substantive information was available. Once the movies did open and information became available—reviews, for instance, or early box office returns—fewer trades were made, an indication that traders continued to rely on their own homework, even when early box office returns suggested their research was wrong.

Gruca says traders who do their own research come to “own” their analysis, and changing their minds is in some ways an admission of personal failure. Writing their analysis deepens the overconfidence, as previous studies—including one from Gruca’s team—have shown. People are more likely to stick to a strategy once they’ve written it down, and in these markets, results showed that every trader was overconfident.

In future research, the team will determine whether traders who do not do their homework are as overconfident as those who do, or if they’re more likely to adapt to new information and avoid bad financial outcomes.

On a theoretical level, Gruca says, the research shows that information does drive markets, and those who have better information will profit at the expense of the less informed.

“The process of seeking an informational advantage over other traders provides the opportunity, through overconfident trading, for better-informed traders to gain significantly superior returns,” Gruca says.

Gruca’s paper, “Private Information, Overconfidence and Trader Returns on Prediction Markets,” was co-authored by Sheila Goins, assistant professor of business administration at Augustana College, and Michael Cipriano, visiting assistant professor of accounting at James Madison University. It appeared in the most recent issue of The Journal of Prediction Markets.