Why individual investors don’t do well

I was listening to the Finametrica podcast and they were talking about The Behavior of Individual Investors paper that they had just come across. It was written in 2001, but as with most papers written about human behaviour, it is still very relevant today. Collectively, the paper found that individual investors underperformed the market, both before and after costs. We will have a look at what their findings are on why people who buy stocks individually do worse than just buying an index.

  • Trading generally hurts performance. Investors who actively trade in taxable accounts will earn lower after-tax returns then buy and hold investors.
  • …investors who trade most actively earn an annual return net of trading costs of 11.4%. Buy and hold investors earn 18.5% net of costs (Investment period of 1991 – 1996).

If buying an index gives you better returns over the long term, why don’t individual investors just do that?

Overconfidence

  • One variety of overconfidence is that an investor thinks he knows more than he actually does.
  • Another variety is the belief that they are better than average.
  • It is found that those that consider themselves to be better than average churn their portfolio more.

Sensation Seeking

  •  A noncompeting explanation for excessive trading of individual investors is the simple observation that trading is entertainment and appeals to people who enjoy sensation seeking activities such as gambling.

Familiarity

  • There is a debate about whether individual investors have an advantage when investing in companies that are located where they live or are in an industry that they work in.
  • The other side of the argument is that because they invest in companies familiar to them, it leads to a lack of diversification and below par returns.

Selling Winners and Holding Losers

  • Individual investors have a strong preference for selling stocks that have increased in value since they bought them relative to stocks that have decreased in value since bought.
  • This is known as the disposition effect and is a remarkably consistent and robust phenomenon.
  • Individual investors are four times as likely to sell a winner rather than a loser.
  • Why do individual investors do this? It is a combination of factors
  • Prospect theory – people will view gains and losses differently and will base decisions on perceived gains rather than perceived losses eg. Which would you prefer? 50% to win €1,000 or a 50% to win nothing?
  • Mental accounting – individual investors will evaluate performance at an individual stock level instead of looking at the portfolio as a whole.
  • Regret aversion – the fear of being left with a feeling of regret if they sell a stock and it rises or buy a stock and it falls. (Secret: this can happen and it’s not your fault!)

Reinforcement Learning

  • The simplest form of learning may be to repeat behaviours that previously coincided with pleasure and avoid those that coincided with pain. Several studies suggest that individual investors engage in such simple reinforcement learning.
  • One study found that if investors experienced greater returns, they increased their savings. Another found that investors are more likely to repurchase a stock that they previously sold for a profit rather than one previously sold for a loss (remember past performance is no guide to to future performance. This is investing purely on emotion and past experience).

Attention: Chasing the Action

  • Individuals have a limited amount of attention that they can devote to investing. Attention can affect the trading behaviour in two ways:
  • Directing too little attention to important information can result in a delayed reaction
  • Direction too much attention to (perhaps stale or irrelevant) information can lead to an overreaction.
  • Individual investors face a huge search problem when choosing which stock to buy. Rather than searching systematically, many investors may consider only stocks that first catch their attention e.g. stocks that are in the news

Failure to Diversify

  • Risk averse investors should hold a diversified portfolio to minimise the impact of idiosyncratic risk on their investments. There is a lot of evidence that suggests that individual investors fail to effectively diversify.
  • Investors who over invest in the stock of their employer are left exposed to the fortunes of their employer for both their regular income and their savings. At the end of 2000, Enron employees 62% of their pensions invested in company stock. Just one year later they were out of work and they lost almost 2/3 of their pension funds.
  • A 2003 study found that five million Americans have over 60% of their assets invested in company stock.
  • Investors prefer local and familiar stocks, avoiding foreign stocks which arguably provide strong diversification.

Conclusion

The investors who inhabit the real world and those who populate academic models are distant cousins. In theory, investors hold well diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice, investors behave differently. They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience. Individual investors who ignore the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment.

In other words, get someone with no emotional involvement in the process to do the investing for you.

If you have any questions, send me an email at steven@bluewaterfp.ie