IOSR Journal of Business and Management (IOSR-JBM) e-ISSN: 2278-487X. Volume 8, Issue 1 (Jan. - Feb. 2013), PP 77-84 www.iosrjournals.org www.iosrjournals.org 77 | Page Investor Overconfidence and Stock Returns: Evidence from Pakistan 1 Beenish Tariq, 2 Naeem Ullah 1 Foundation University Institute of Engineering & Management Sciences 2 Foundation University Institute of Engineering & Management Sciences Abstract: The study investigates investor overconfidence in Pakistan stock market. By taking daily stock prices of 27 leading companies representing all sectors of Karachi stock exchange we found that return of the securities have impact on securities’ trading volumes. While trading volumes failed to impact returns in short term horizon. Further returns volatility had impact on the returns but failed to impact trading volume. This indicates that despite return volatility, overconfident Pakistani investor continue to trade in the security. Impulse response analysis exhibits that trading are impacted by one standard deviation of security return but they still remain positive and mostly stay above zero. The study was conducted in vector auto regressive environment. Key words: Investor overconfidence, Returns, Volatility, Vector Auto regression I. Introduction The history of stock markets is full of events that made mark on the history. The crash of 1929 of U.S stock markets; Black Monday crash of 1927; Dot Com bubble burst and Crash of Asian stock exchanges in 90s; market liquidity crunch of 2007 are the events that refer to dramatic changes in stock prices and trading volumes. The standard finance models of sharpe (1964), Linter (1965) and Black (1972) were helpless in explaining these anomalies. Thus the best way to explain such phenomena is to study the behavior of the people who were at the heart of these crises. The standard flaw in these models was assumption of “rational investor” which in the world lead by perception is difficult to be found. Thus researchers of behavioral finance tried to augment them with alternative model that takes into account irrational behavior of the investor. Delong, Shleifer, Summers, and Waldmann (1990) were the first to give the idea of investor sentiments. They posit that investors are governed by beliefs of future cash flows and not by the facts regarding risks of such future benefits. Further they argued that rational investor should not compete with sentimental investor because it’s costly and risky. Thus they are unable to bring the prices to their fundamental values. Thus it’s the major assumption in behavioral finance literature that there are no limits to arbitrage. The Dot Com bubble supported this theory with flying colors. The periods of enthusiastic investor sentiments pushed the price to an unprecedented level. The arbitragers were unable to correct the market because of high prices and went out of business. Thus studying investor sentiment is they key to understand the behavior of today’s stock markets. Getting in-depth knowledge of investor sentiments by digging into the factors that contribute to it, quantifying them and how they affect sentiment is of paramount importance in the research of today. The most powerful factor in this relation is investor overconfidence. Overconfidence relates to investors belief that he is precise in his prediction of stock returns and because of this misconception he continue trading (Odean ,1998a). Odean (1999) posits that those investors who trade more tends to loose more. The bullish behaviour of stock markets mistakenly leads investor to believe that his investment skills are superior. Thus he keeps on investing and raising trading volumes. Further, overconfident investor do not reduce their trading activities in the same ratio as market is declining. This tendency is responsible for higher trading volumes even in the wake of declining trend in the market. However, investor overconfidence should not be confused with investor disposition-a tendency to sell securities in time of rising prices to gain profit and retain them in time of price drop in anticipation that loss can be avoided when prices rise again. This concept is discussed in detail in literature. Most of today’ s researchers are relying on investor confidence to explain market behavior. Trading volumes are taken as proxy for investor overconfidence in recent studies (see for example Shefrin and Statman, 1985; Statman et al., 2006; Goetzmann and Massimo, 2003; Odean, 1998b; Ranguelova, 2001). All these studies take into account the investor overconfidence to explain returns and vice versa. There is a debate whether returns impact on investor overconfidence or vice versa This study will take investor overconfidence to see whether Pakistani stock market’s returns are dependent on overconfidence of investors or whether returns themselves determine the trading volumes. The