Causality Illusion and Overconfidence in Predicting (Quasi)Stochastic Financial Events

Abstract

Causality Illusion and Overconfidence in Predicting (Quasi)Stochastic Financial EventsWe argue that individuals systematically interpret sequences of events in a causal manner.The aim of this article is to show that people do so even if they are aware of the stochastic nature of the respective sequence.The bias can explain some anomalous behaviour of investors in financial markets.Small as well as professional investors may illusorily perceive causality of former random success and future yield.Laboratory experiments testing the interpretation of stochastically occurring events in financial designs as well as analyses of real trading data from financial markets confirm that investors indeed interpret (quasi)random events casually; they make incorrect predictions and they egocentrically allocate responsibility for their success.The causality illusion induces overconfidence, inefficient investment and risk seeking.In the conclusion, we discuss factors that may limit effects of the causality illusion and suggest future areas for research.

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