How investors get it wrong
‘We trade too often because we’re too confident in our ability to spot the latest bargain’
Flip through the pages of this august newspaper and you will often see reference to how particular investments are doing: gold is up, oil is down and the S&P 500 is going sideways.
Yet illuminating as all this might be, such reporting draws a veil across what we might call the Investor’s Tragedy: that the typical investor doesn’t do nearly as well as the typical investment.
This isn’t just because Wall Street and the City of London cream off all the money, although of course there is something in that. (In 1940, the author Fred Schwed invited us to contemplate the yachts of all the brokers and bankers riding at anchor off downtown Manhattan; the title of Schwed’s book was Where Are the Customers’ Yachts?)
No, the Investor’s Tragedy wouldn’t be much of a tragedy if it was all somebody else’s fault. Alas, the fault is not in our stars but in ourselves: we underperform the market because we’re doing it wrong.
Our first tragic flaw is that we buy and sell too often. In 2000, Brad Barber and Terrance Odean studied the trading performance of more than 65,000 retail investors with accounts at a large discount broker. Looking at the early 1990s – happy days for investors – Barber and Odean found that while an index reflecting US stock markets returned 17.9 per cent a year, the investors who traded most actively earned just 11.4 per cent a year – a huge shortfall that becomes even more dramatic after a few years of compounding.
Hyperactive investors paid corrosive trading costs while failing to improve their underlying investment performance. The typical investor traded less and underperformed by 1.5 per cent per year, a substantial margin. The investors who hardly traded at all were rewarded with market-matching investment performance.
Our second tragic flaw is our tendency to buy high and sell low. Apologies if this is all a bit technical but it turns out that buying high and selling low is not the aim of the investment game.
Here’s how the self-deception works. You put $10,000 into the stock market. It promptly doubles, leaving you with $20,000. So pleased are you that things are going well that you double up, putting a further $20,000 into the market. Now the market falls back to its original level. Licking your wounds, you sell half your shares for $10,000. The market promptly doubles again, leaving you holding $10,000 in cash and $20,000 in shares after investing a total of $30,000. The market has, after a rollercoaster ride, risen by 100 per cent – but somehow you haven’t made a penny of profit.
The most influential study of such behaviour was published in the American Economic Review in 2007 by Ilia Dichev, now at Emory University. Dichev found that dollar-weighted returns were several percentage points lower than buy-and-hold returns: the market did better when only a few people were in it. A number of subsequent studies have examined this tendency, and while not all of them reach the same gloomy conclusion, many do.
Dichev’s work makes sense in the light of research on the psychology of investment. Robert Shiller, one of the most recent winners of the Nobel memorial prize in economics, has found that stock markets tend to revert to long-run average valuations. When things are booming a bust is on the way, and vice versa.
Meanwhile Stefan Nagel and Ulrike Malmendier have discovered that stock market returns in our formative years shape a lifetime of investment behaviour. An awful bear market scares a generation of young investors away, just as they are being presented with a buying opportunity.
Two tragic flaws are probably enough but here’s a third: Odean also showed, in 1998, that investors had a tendency to sell shares that had risen in value while holding on to losing investments, despite tax incentives pushing in the opposite direction. In Odean’s sample of investors, this bias pulled down investors’ returns.
Explanations for these shortcomings aren’t hard to find. We trade too often because we’re too confident in our ability to spot the latest bargain. We buy at the top and sell at the bottom because we’re influenced by what others are doing. And we hold on to shares that have fallen in value because to sell them at a loss would be admitting defeat. (Anyway, those shares in Lehman Brothers are sure to bounce back at some point.)
Armed with a diagnosis, a cure is also readily available: make regular, automated investments in boring, low-cost funds and try to sell in a similarly bloodless fashion.
Unfortunately this advice doesn’t really fit the modern world. The default option for financial reporting is to tell us what the market has done in the past few hours and how everyone is feeling about that. It is hard to think of a brand of journalism more calculated to breed a herd mentality.
Meanwhile, it has never been easier to fidget with our investment portfolios. Investment platform providers have every incentive to turn their websites into something like Facebook, constantly poking us for attention.
Our investments would be far healthier in the equity market equivalent of an old-fashioned piggy bank; the sort that needs a hammer to open.
Also published at ft.com.