Stock market is no place for cheap thrills

Trading for the sake of trading tends not to be a profitable endeavour

New York Stock Exchange: many studies confirm that stock markets are not the preserve of hard-headed financial types. Photograph: Michael Nagle/Bloomberg

New York Stock Exchange: many studies confirm that stock markets are not the preserve of hard-headed financial types. Photograph: Michael Nagle/Bloomberg

 

Are you investing in stock markets to boost your finances or because you are looking for a little excitement? Or is a bit of both, perhaps?

The investors that populate academic models want to maximise their financial welfare, so they diversify widely, trade infrequently and pay not a second’s thought to questions of excitement and the likes.

However, these sensible creatures are “distant cousins” to real-world investors, to quote California-based behavioural finance professors Brad Barber and Terrance Odean. Real-life investors, they noted in their 2011 paper, The Behavior of Individual Investors, “trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses”.

Market kicks

A 2009 Finnish study, for example, found a correlation between speeding tickets and trading activity, with fast drivers more likely to churn their portfolios. Speeding fines are tied to income in Finland – the paper notes that one wealthy businessman was hit with a €170,000 fine for speeding, while a Nokia executive received an €80,000 ticket – so it’s a reasonable assumption that one would have to be a bit of a daredevil to ignore the Finnish speeding laws.

Similarly, while stock market participation is perceived as financially risky, it “lacks novelty and variety” in the absence of trading. Active trading, like risky sexual behaviour and drug and alcohol abuse, bungee jumping and gambling, may be a “sensation-seeking” activity, researchers suggest.

Lottery jackpots

This so-called substitution effect was also noted in another study that looked at trading of Taiwanese stocks over the 2002-09 period: trading volumes fell when lottery jackpots hit especially high levels, with the biggest declines occurring in highly volatile small-cap momentum stocks. A large jackpot, the paper concluded, “satisfies investor needs and caters to preferences that are similar to stock trading”.

Various other studies confirm that stock markets are not the preserve of hard-headed financial types. A Yale study of investors during the 1999-2000 dotcom bubble era found that a quarter said they bought stocks as a hobby or because it was something they enjoyed doing.

A 2007 survey of 5,500 clients at a Dutch discount brokerage which asked respondents to indicate their most important investment objective found that “entertainment and gambling” was the second most popular answer: almost 40 per cent chose this option, way above other options such as “building a financial buffer” and “saving for retirement”.

Unsurprisingly, such investors overtrade: Trading as Entertainment, a 2007 study of more than 1,000 clients at a German discount brokerage, found that most “entertainment-driven investors” traded roughly twice as much as clients who were not investing for pleasure.

Needless to say, investing for the fun of it doesn’t yield great results. One famous Barber and Odean study of some 65,000 US discount brokerage clients found that the most active traders underperformed the least active segment by more than seven percentage points a year.

A separate study by the same authors found that trading results in “systematic and economically large losses” for Taiwanese investors, “equivalent to 2.2 per cent of Taiwan’s gross domestic product or 2.8 per cent of the total personal income”.

Aggressive investing may be bad for one’s wealth but, as the authors of Trading as Entertainment note, that doesn’t mean it necessarily “reduces investor welfare”. They compare recreational and sensation-seeking investors to lottery players who know their chances of a win are slim but who buy tickets anyway.

Nonpecuniary benefit

Nevertheless, active investing may not be the healthiest of hobbies, as noted by acclaimed finance columnist Jason Zweig in his book Your Money and Your Brain. In the book, Zweig relates research by Harvard neuroscientist Hans Breiter which compared activity in the brains of cocaine addicts expecting to get a fix to people expecting to make a profitable financial gamble.

“The similarity isn’t just striking,” writes Zweig, “it’s chilling. Lay an MRI brain scan of a cocaine addict next to one of somebody who thinks he’s about to make money, and the patterns of neurons firing in the two images are ‘virtually right on top of each other’, says Breiter. ‘You can’t get a better bull’s-eye hit than those two’.”

Winner effect

John Coates

However, this “winner effect” may prove temporary, according to Coates, as chronically elevated testosterone levels are also associated with impulsivity and sensation seeking.

There is also a danger that investors may engage in risky activities if they observe others doing so. In a recent experiment conducted by California neuroscientists, participants were given four seconds to decide whether they wanted to accept a certain gain of $10 or to gamble on gaining a bigger amount. Some participants were also asked to witness the choice made by others. Most people took the guaranteed $10. However, if they witnessed other participants electing to gamble, they tended to follow suit, even though they were not allowed to see if the outcome was successful.

JP Morgan famously said that nothing undermined your financial judgment as much as the sight of your neighbour getting rich, but this study indicates simply witnessing your neighbour’s actions impairs financial judgment, irrespective of whether they get rich or not.

Nor are investors quick to wise up to the dangers of excessive risk-taking. Famous experiments conducted by Nobel economist Vernon Smith showed that when participants were given cash to buy and sell computer-generated financial assets, bubbles tended to develop. Prices eventually collapsed, but the same pattern tended to play out when the subjects played a second round of the game.

“The old adage ‘Once burned, twice shy’ is wrong,” writes Zweig. “Because being on a roll is so thrilling, it generally takes at least two scaldings before even so-called experts can begin to learn not to touch a market bubble.”

Lasting impact

Younger investors, on the other hand, are less likely to be scarred by those experiences, and the relative exuberance of youth (note that the aforementioned Finnish study found both speeding fines and trading activity declined as one got older) means some will undoubtedly seek to purge their sensation-seeking desires via the stock market.

The rollercoaster ride they seek may indeed prove to be exhilarating; whether it will prove financially rewarding is another matter entirely.

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