Optimistic, but Selling Riskier Stocks – An Arbitrage Experiment in Crisis Market

Abstract

The field-based experimental approach was utilized to collect expectations-arbitrage portfolios from more than 100 competent investors at the pick of the financial crisis. The average annual return on 117 portfolios was 5.2% with 55% profitability rate. Prior self confidence emerges as the strongest predictor of eventual performance, and yearly returns reach 26% for the highest confidence quartile. The stocks selected for short sale were riskier than the stocks selected for purchase and time-series estimations confirmed that the unbalanced positions diminished profitability while markets recuperated. As most participants anticipated the recovery at the time of decision, the selling of riskier stocks suggests that “misperception of financial risk” impaired performance.

Keywords: arbitrage in expectations, sub-prime crisis, self-confidence, misperception of financial risk

JEL Classification: C9, G1, D8