Brad Barber and Terrance Odean have written a series of papers on individual investors. Their latest is the September 2011 paper, "The Behavior of Individual Investors." The studies have provided evidence that individual investors don't behave rationally, as economic theory would suggest they do. The paper is provides an overview of research on the stock trading behavior of individual investors. The following is a summary of their findings:
- In aggregate, individual investors underperform standard benchmarks (such as low cost index funds) even before costs -- when they trade they are exploited by institutional investors -- or taxes. Similar results are reported for individual investors in other countries.
- There's a wide dispersion of results among individual investors. However, even the best traders have a hard time covering costs.
- They have a strong preference for selling winners and holding onto losers (what is called the "disposition effect) -- maximizing their tax bill.
- They engage in naÃ¯ve reinforcement learning by repeating past behaviors that coincided with pleasure (such as buying a stock they had previously made money on or buying stocks from the same industry in which they had previous winners) while avoiding past behaviors that generated pain (such as realizing losses).
- They tend to hold undiversified stock portfolios -- overweighting stocks of their employers and others that are located close to where they live -- resulting in unnecessary levels of idiosyncratic (and thus uncompensated) risk. A dramatic example would be that Enron employees had 62 percent of their retirement plan assets invested in company stock at the end of 2000. By December 2001, the company had declared bankruptcy, and its employees had lost both their jobs and a large fraction of their retirement income.
- They tend to buy (rather than sell) stocks when those stocks are in the news. This attention-based buying leads them to trade speculatively and has the potential to influence the pricing of stocks.
These behaviors negatively affect the financial well being of individual investors. This raises such questions as: "Why do so many investors self-manage portfolios when they could earn better returns with lower risk in low-cost mutual funds, such as index funds? And why do investors with portfolios of individual equities actively trade when doing so lowers their expected returns?"
Among the answers are:
- They're overconfident of their skills -- a well-documented all-too-human trait.
- Trading is entertaining and appeals to people who enjoy sensation-seeking activities such as gambling.
- They're unaware of how bad they're doing.
The authors of the study "Why Inexperienced Investors Do Not Learn" found:
- Investors are unable to give a correct estimate of their own past portfolio performance. The correlation coefficient between return estimates and realized returns wasn't distinguishable from zero.
- People overrate themselves. Only 30 percent considered themselves to be average. Investors overestimated their own performance by an astounding 11.5 percent a year. And portfolio performance was negatively related with the absolute difference between return estimates and realized returns -- the lower the returns, the worse investors were when judging their realized returns. It seems likely that investors are unable to admit how badly they've done. While just 5 percent believed they had experienced negative returns, the reality was that 25 percent did so.
- On average investors underperformed relevant benchmarks. For example, while the arithmetic average monthly return of the benchmark was 2.0 percent, the mean gross monthly return of investors was just 0.5 percent. And over 75 percent of investors underperformed.
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