More Benefits From Overconfidence
Eric Falkenstein | Jun 03, 2013 02:13AM ET
Overconfidence may cause people to invest too much in volatile stocks because such stocks have a greater diversity of beliefs, and so if people dismiss the objectively bad odds of beating the market, such people will be drawn to stocks where they are in the extremum, and highly volatile stocks have the most biased extremums. One might think these people are irrational, but in the big picture people with this bias actually have a huge advantage, why Danny Kahneman said it's the bias he most wants his children to have.
Two economists at Washington State University looked at New York Fed economists find that a particular DSGE model predicted the 2008 fiasco just about perfectly.
This is all 'out of sample', in the same way the test data for neural nets is out-of-sample: if you exclude all the hundreds of functional forms that were tried that didn't work, one of them was fit to only prior data and predicted the out-of-sample data. That is, the projection from 2008 is being done in 2013. The degrees of freedom in this model would make a technical analyst blush. I can understand the allure of this approach (economics is about modeling), but anyone who has been around a while should cop to the patent overfitting that goes on 'outside the model'. I would bet anyone that if they set this model up in real time, it will miss the next turning point...and there will be another DSGE model that would have worked.
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