II.

Literature review and hypothesis development

Theoretical background (Slide 1)

“Traditional finance” emphasizes the rationality of individual investors, seeking to

optimize their wealth or utility through comprehensive consideration of available information,
with a primary focus on the "what" of investor decisions.
“Behavioral finance” the psychological and behavioral factors shaping investor decision-
making, encompassing social influences, cognitive biases, emotions, and psychological
processes, behavioral finance focuses on the “why” of investor decision-making (Gupta, 2023 )

1. Confidence

“Confidence is a sentiment or mental state wherein individuals believe in their

capabilities. Moreover, overconfidence occurs when individuals overestimate their abilities”
(Daniel & Titman, 2000).

Investment decisions are significantly influenced by overconfidence (KARTINI &

NAHDA, 2021). Overconfidence has an impact on trading volume and affects investment
growth, investor overconfidence leads to excessive trading due to positive returns, causing
inefficiencies in stock markets (Bouteska, 2023). Overconfidence leads to higher trading volume
and weakly damages profits (Bregu, 2020). Excessive trading of overconfident market players
significantly contributes to the weekly volatility (Kuranchie-Pong & Forson, 2022). Investors
associate significant returns with the precision of their private information and the excellence of
their investment skills. Consequently, they engage in more frequent trading, leading to a rapid
increase in trading volume (Jiayu Huang, 2022). The analysis of small stocks shows that
conditional volatility is positively related to trading volume caused by overconfidence
(Mushinada & Veluri, 2020)

Based on prior research, we construct a hypothesis:

H1: Confidence has an impact on trade volume.

2. Pessimism

“Pessimism in behavioral finance refers to a psychological bias where individuals tend to

have a more negative outlook on future outcomes than what is objectively warranted by available
information.”
Pessimism is “a tendency to see the worst aspect of things or believe that the worst will
happen; a lack of hope or confidence in the future.” (Carbonneau, 2024).
 The result of previous papers showed that pessimism has a positive impact on trading
volume (Rashid, Tariq, & Rehman, 2021); a rise in pessimism among retail investors coincides
with declining current market returns, alongside an uptick in volatility and trading volume.
Conversely, future returns typically rise as future volatility and trading volume decrease (Dimpf
& Kleiman, 2019), and high or low levels of pessimism would forecast trading volume
(Brochado, 2020). According to KARTINI & NAHDA (2021), pessimism has a positive impact
on trading volume. Be consistent with the mentioned findings, the below hypothesis was built:

H2: Pessimism has an association with the volume of trading.

3. Optimism

Optimism is defined as “hopefulness and confidence about the future or the successful
outcome of something.” (Carbonneau, 2024).

Optimism refers to a cognitive bias wherein individuals tend to have a more positive
outlook on future outcomes than what is objectively warranted by available information. This
bias often leads individuals to overestimate the likelihood of favorable events and underestimate
the probability of adverse outcomes. Optimism can influence investment decisions, risk-taking
behavior, and financial decision-making processes.

Some previous results indicated that investment decisions are significantly affected by
optimism (KARTINI & NAHDA, 2021), optimism negatively affects the trading volume
(Rashid, Tariq, & Rehman, 2021), irrational investors are more likely to trade when optimistic
and speculate on stocks rising than when they are pessimistic (Hanna, 2020). Positive
announcements fuel investors' overly optimistic expectations regarding future news,
consequently causing overreactions and resulting in increased trading activity. (Ravazzolo,
2019). Based on previous results, one hypothesis was constructed to examine the relationship
between optimism and trade volume:

H3: Optimism is associated with trade volume.

4. Rational expectation

The theory of rational expectations posits that individuals base their decisions on the
most reliable information in the market and incorporate lessons from past trends. It implies that
while individuals may occasionally err, their overall accuracy tends to be high. The idea of
rational expectations was first developed by American economist John F. Muth in 1961 (Muth,
1961), however, it was popularized by economists Robert Lucas and T. Sargent in the 1970s and
was widely used in microeconomics as part of the new classical revolution (Sargent & Lucas,
1981).

Investors condition demands on their rational expectations of trading volume (Luo &
Mao, 2021). In an efficient market, asset prices reflect all available information, investors rely on
equilibrium prices as a robust foundation for adjusting their expectations in response to new
market information (KARTINI & NAHDA, 2021). In contrast, one paper showed that the
investors’ rational expectations fail to explain trading volume variability (Oprean & Tanasescu,
2014).

Therefore, we construct the below hypothesis to test the relationship between rational
expectation and trade volume:

H4: Investors’ rational expectation has an impact on the volume of trade.

References
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Further evidence from the U.S. market. Research in International Business and Finance,
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Bregu, K. (2020). Overconfidence and (Over)Trading: The Effect of Feedback on Trading
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Brochado, A. (2020). Google search based sentiment indexes. IIMB Management Review, 23(3).
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