The Curious Case of Negative Volatility and Other Puzzles in Household Finance

Abstract

Many individual investors struggle in financial markets, because they believe investing is about predicting the state of the economy, the performance of companies, and the return of assets. As even professionals fail at this task on a regular basis, we deem it next to impossible for the average private household. The consequence of this is twofold: a large group of people will abstain from financial markets as they consider themselves unequipped to deal with risky investments, while another group will seek out these risks in a false sense of having understood the market. Not only do individual investors notoriously underperform common benchmarks, but they are also prone to investment mistakes such as overtrading or underdiversification.

The expectations of these investors are very informative as to how such suboptimal decisions come about. A common theme in this respect is overconfidence, which is present in expectations in various forms. The inaugural lecture will highlight a peculiar form of overprecision in expectations, the belief that the return of the own portfolio is relatively certain, while the overall market is uncertain. As portfolios depend on market outcomes to a large extent, this creates a logical impossibility – negative volatility.  Such inconsistent beliefs have a strong effect on the chosen degree of portfolio diversification. The lecture will also provide an outlook on ongoing research, studying overconfidence in debt decisions.

Biography

Christoph Merkle is Associate Professor of Finance at Kühne Logistics University. From 2012 to 2017 he was Assistant Professor of Finance and Banking at the University of Mannheim, where he also obtained his PhD. Before, he studied Economics at the University of Cologne. He was a visiting scholar at Duke University, Fuqua School of Business, and Aalto University.

Merkle’s research interests include Behavioral Finance, Household Finance, Experimental Economics, Decision Theory, and Financial Forecasting. Among other topics, he analyzes how individual investors convert their beliefs and preferences into actions in financial markets. In newer work, he explores how financial professionals process information and form expectations.