Ordinary investors badly underperform stock markets for a multitude of reasons. The biggest sin of all, though, is surely investors’ tendency to over-trade. How much money does over-trading cost investors, and what are the factors driving this counter-productive behaviour?
The best-known researchers in this field are behavioural finance experts Brad Barber and Terrance Odean, whose examination of more than 66,000 trading accounts at a US brokerage led them to conclude that "those who trade the most are hurt the most" – the most active clients underperformed the least active by more than 7 percentage points annually. The main reason was trading costs such as commissions and bid-ask spread; even the best stock pickers have trouble covering transaction costs, they noted. Over-trading is an even bigger problem in Taiwan, according to the same researchers; there, investor losses are equivalent to 2.2 per cent of Taiwan's gross domestic product (GDP).
European data is similarly dispiriting, one study finding investors at a Swedish discount brokerage typically underperformed the market by about 8.5 per cent annually. About half of this underperformance was attributed to trading costs. What about the other half? Even before costs, ordinary investors tend to screw up. Data from the US, Asia and Europe all confirms they have an uncanny ability to buy the wrong stocks. This “perverse” trading ability, as Barber and Odean put it, means the stocks they buy typically do worse than the stocks they sell.
Young men take lots of ill-advised risks, so it’s little surprise they’re prone to over-trading. A recent study of data pertaining to 7,200 British investors,
Who Trades Profusely? The Characteristics of Individual Investors who Trade Frequently,
found there were five times as many male traders as there were female. The most frequent traders, the study found, were young men.
Another Barber and Odean study, Boys will be Boys, found men traded 45 per cent more often than women and earned 1.4 per cent less annually. Single men were especially guilty, trading 67 per cent more than single women and earning 2.3 per cent less annually. Both men and women are poor at picking stocks, the study found; the difference in returns is almost entirely due to men's aggressive trading.
The pursuit of profits is not the only driver of trading activity. Multiple studies confirm thrill-seeking is a factor.
In Finland, for example, fast drivers are more likely to be fast traders, with research confirming that frequent traders were more likely to have been fined for speeding. A separate study examining investor behaviour in Germany found "entertainment-driven" clients traded twice as much as clients who were investing for profits rather than pleasure.
US research shows an increase in lottery jackpots is linked to a reduction in stock market activity by small traders, with this effect most pronounced among lottery-like stocks (that is, low-priced, volatile stocks). The connection between lotteries and stock market activity is even more obvious in Taiwan, where trading activity plummeted by a quarter when a government-sponsored lottery was introduced in 2002. More recent Taiwanese data shows this substitution effect remains alive and well, with trading volumes declining when lottery jackpots hit unusually high levels. As in the US, the most volatile small-cap stocks – that is, lottery stocks more likely to be traded by individual investors rather than institutional investors – register the biggest declines in trading volumes.
Driven by desperation
As we’ve seen, there’s more than a little truth to the stereotype of the amateur stock market trader as a fast-living type with an outsized appetite for risk. Sometimes, however, the reality is more mundane – trading may be driven by desperation.
One Swedish study, for example, found the most frequent traders had lower incomes, less wealth and less education, indicating trading losses are "mainly borne by those who can least afford them". The same picture emerges from US research. One study found clients with less wealth, minority groups and even the elderly are most likely to engage in excessive trading. Another study, Who Gambles in the Stock Market?, noted lottery purchases are influenced by "socio-economic and psychological factors". Although some people buy lottery tickets for entertainment purposes, research suggests poor people are more influenced by a strong desire to escape poverty and to rise in social status.
Might these same factors drive investment in lottery-like stocks, the researchers wondered? Short answer: yes. Such stocks are most popular among “poor, young men who live in urban, Republican-dominated regions and belong to specific minority (African-American and Hispanic) and religious (Catholic) groups”, the study found. Furthermore, demand for lottery-type stocks increases during bad economic times.
Investing in lottery-type stocks costs investors roughly 5 per cent of their annual household income, the researchers found. Worse, the poorest investors – those with an annual income of $15,000 or less – experienced an average underperformance of $4,725, almost a third of their annual income. “Investors who are predisposed to playing lotteries also exhibit strong preferences for lottery-type stocks in their investment choices,” the study concluded. “More importantly, and sadly, poor investors, who can least afford to under-perform, incur the largest costs for their gambling-motivated investments.”
Barber and Odean have long contended that those who over-trade tend to be over-confident, a finding backed up by European data. One German study of 1,345 investors found those who think themselves to be more knowledgable than average are more prone to churn their portfolios. Similarly, the aforementioned Finnish study on the link between thrill-seeking and trading activity found overconfidence was also an important factor – investors with inflated views of their abilities tended to trade more.
Psychologists have long demonstrated that human and animal behaviour is shaped by reinforcement. Rewarding your dog with a treat after he agrees to sit; praising your daughter for doing her homework; giving your son sweets because he cleaned up his room – these are all acts of reinforcement that shape beliefs and behaviours.
Reinforcement also drives trading activity. Investors are more likely to repurchase a stock they previously sold for a profit than one previously sold for a loss, according to Barber and Odean. Other researchers have found investors – especially unsophisticated investors – are more likely to buy a stock in an industry if their previous investments in this industry have been successful; more likely to invest in stocks if they have experienced high stock returns throughout their lifetimes; more likely to buy into initial public offerings (IPOs) if their earlier IPO investments have been profitable; and more likely to trade actively when their most recent trades have yielded profits.
Such investing is not guided by rational decision-making; rather, investors are simply engaging in “naive reinforcement learning”, say Barber and Odean, “by repeating past behaviours that coincided with pleasure while avoiding past behaviours that generated pain”.