The Impact of Investor Overconfidence on Stock Market Volatility: The Role of Risk Perception and Financial Literacy in Pakistan

Abstract

Current research investigate the association between investor overconfidence, risk perception, and stock market volatility, with a specific emphasis on the moderating effect of financial literacy. Based on data collected from a sample of retail investors who trade in the Pakistan Stock Exchange (PSX), this study uses structural equation modelling (SEM) techniques to examine the research hypotheses. The results show that investor overconfidence has a significant effect on risk perception, which then enhances stock market volatility. The modulation by financial literacy was, however, limited when considering the attenuation of confidence in risk perception and market volatility. These findings indicate the importance of psychology to determine investment behavior and market outcomes and shed some light on how behavioral biases may lead to volatile behaviors in emerging markets. In addition, the findings add empirical evidence on the behavioural finance literature from the perspective of a developing country, Pakistan. The results have policy implications for policymakers and financial intermediaries who wish to improve investor education and lower the destabilizing impact of irrational investment behavior on market stability.