Study notes of individual investors behaviors from Barber & Odean 2012. This includes discussion of some traps to individual investors. And systematic investors should avoid those traps when building their own strategies, or even “speculate” from these observations.
Underperforming Standard Benchmarks
The majority of the empirical evidence indicates that individual investors, in aggregate, earn poor long-run returns and would be better off had they invested in a low-cost index fund. This evidence of poor performance is particularly compelling when we include transaction costs. Other than transaction costs, poor security selection ability of individual investors is documented in many studies.
There are 4 possible explanation for their underperformance.
Asymmetric Information
- Investors may need to purchase stocks to save or sell stocks to consume.
- Investors may need to rebalance their portfolios to manage risk-return tradeoffs.
- Invetors will want to harvest tax losses to minimize their tax bill.
When faced with these liquidity, rebalancing, or tax management needs, retail investors are forced to trade with others who might be better informed.
Overconfidence
For the 20% most active investors in the LDB dataset, the annual turnover rates is 250%. In Taiwan and China, the numbers are 300% and 500% respectively. Overconfidence can explain the relatively high turnover rates and poor performance of individual investors. One variety of overconfidence is a belief that one knows more than one actually does, which is somtimes labeled “miscalibration” or “overprecision.” A second variety of overconfidence is a belief that one is better than the madian person, which has been (mis)labeled the “better-than-average” effect. Related to, but distinct from, the better-than-average effect is the tendency to overestimate one’s actual ability.
Sensation Seeking
A noncompeting explanation for the 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. In related papers it was hypythesized taht retail investors have a taste for stocks with lottery-like payoffs. Note that this is distinct from the sensation-seeking hypothesis discussed above. Sensation-seeking investors will trade to entertain themselves but might hold well-diversified portfolios and eschew lottery-like stocks. Investors with a preference for skewness will hold lottery-like stocks but might refrain from trading. Thus, preferences for skewness may lead to underdiversification but has no immediate implications for trading.
Familiarity
There is debate about whether individual investors possess an informational advantage about companies that are close to where they live or in their industry of employment. Some scholars argue that individual investors are better informed about the prospects of such companies and that this information advantage leads to superior investment performance. Others argue individuals overinvest in these stocks because they are familiar to them, leading to under-diversification and average or even below-par returns.
Disposition Effect
Individual investors have a strong preference for selling stocks that have increased in value since bought (winners) relative to stocks that have decreased in value since bought (losers).
The Evidence
Disposition effect is a remarkably consitent and robust phenomenon. A number of studies—both experimental and empirical—confirm the presence of the disposition effect. Consistent with this investment behavior being a mistake that has its origins in cognitive ability or financial literacy, the disposition effect is most pronounced for financially unsophisticated investors. Finally, in the LDB data, investors who place more trades on the same day are less likely to exhibit the disposition effect and the disposition effect is greatest for hard-to-value stocks. There is also intriguing evidence that investors learn to avoid the disposition effect over time.
Why to Sell Winners?
While the tendency of investors to sell winners more readily than losers is empirically robust, recent research focuses on why investors behave this way.
Barberis and Xiong (2009, 2012) argue that investors gain utility from realizing gains and dub this behavior “realization utility”. They show that, if gains and losses are evaluated when they are realized, a disposition effect obtains. In ongoing work using brain imaging (fMRI) while subjects are making buying and selling decisions in an experimental market, Frydman et al. (2011) present intriguing results that are consistent with the notion that investors get a burst of utility when they sell a winner.
Summers and Duxbury (2007) examine the role of emotions in creating the dis- position effect.They find no disposition effect in experimental markets when subjects do not actively choose the stocks in their portfolios; if subjects do not feel responsible for decisions leading to gains and losses, they no longer sell winners more readily than losers.This suggests that the emotions of regret and its positive counterpart—referred to by some authors as rejoicing and by others as pride—contribute to the disposition effect. Muermann and Volkman (2006) develop a model of the disposition effect in which investors respond to anticipated regret and pride. Strahilevitz, Odean, and Barber (2011) document that individual investors are more likely to repurchase a stock that they have previously sold if the price has dropped since the previous transaction.They attribute this behavior to the emotions of regret when one repurchases at a higher price than one sold at and rejoicing when one repurchases at a lower price. Consistent with this emotional story, Weber and Welfens (2011) confirm in experiments that subjects exhibit this behavior only when they were responsible for the original sale, suggesting that investors refrain from repurchasing stocks at a higher price than their previous sale price to avoid regret.
Naive Reinforcement Learning
The simplest form of learning may be to repeat behaviors that previously coincided with pleasure and avoid those that coincided with pain. Several studies suggest that individual investors engage in such simple reinforcement learning.
- Choi et al. (2009) document that investors overextrapolate from their personal experience when making savings decisions; investors whose 401(k) accounts have experienced greater returns or lower variance increase their saving rates.
- Strahilevitz, Odean, and Barber (2011) find that investors are more likely to repurchase a stock that they previously sold for a profit than one previously sold for a loss.
- Huang (2010) demonstrates that investors, particularly unsophisticated investors, are more likely to buy a stock in an industry if their previous investments in this industry have earned a higher return than the market.
- De, Gondhi, and Pochiraju (2010) show that individual investors trade more actively when their most recent trades are successful.
- Kaustia and Knupfer (2008) document that investors are more likely to subscribe to initial public offerings (IPOs) if their personal experience with IPO investments has been profitable.
- Malmendier and Nagel (2011) establish that investor age cohorts who have experienced high stock market returns throughout their lives are less risk averse and more likely to invest in stocks.
Buying Behavior
Individuals have a limited amount of attention that they can devote to investing. Attention can affect the trading behavior of investors in two distinct ways. On one hand, directing too little attention to important information can result in a delayed reaction to important information. On the other hand, devoting too much attention to (perhaps stale or irrelevant) information can lead to an overreaction.
Distracted investors miss important information. And investors devoting too much attention overreact.
- Hirshleifer, Lim, and Teoh (2009) find that the market reaction to an earnings surprise is smaller and post-earnings announcement drift is greater for firms that announce earnings on days that many other firms announce earn- ings; they argue that this is because more firms are competing for investors’ attention.
- Similarly, Dellavigna and Pollet (2009) document the market reaction to Friday earnings announcements is muted and the drift is greater; they argue investors are distracted on Fridays and are unable to fully process Friday announcements.
- However, Hirshleifer et al. (2008) are unable to link post-earnings announcement drift to the trades of individ- ual investors in the LDB dataset, who tend to be net buyers subsequent to both positive and negative extreme earnings surprises.
- Barber and Odean (2008) argue that attention greatly influences individual investor purchase decisions. Investors face a huge search problem when choosing stocks to buy. Rather than searching systematically, many investors may consider only stocks that first catch their attention
- Barber and Odean find that individual investors in the LDB and FSB datasets execute proportionately more buy orders for more attention-grabbing stocks.
- Seasholes and Wu (2007) document positive buy-sell imbalances for individual investors when stocks hit upper price limits.They argue that hitting an upper price limit is an attention-grabbing event and find that imbalances are most positive when few other stocks hit upper price limits on the same day. Even investors who have never previously owned a stock are more likely to buy when stocks hit these limits. Seasholes and Wu also find that other (rational) investors systematically profit at the expense of the attention driven individual investors.
- Engelberg and Parsons (2011) find that individual investors are more likely to trade an S&P 500 index stock subsequent to an earnings announcement if that announce- ment was covered in the investor’s local newspaper. Both buying and selling increase, though buying somewhat more than selling.
- Da, Engelberg, and Gao (2011) use Google search frequency as a measure of inves- tor attention to analyze whether investor attention can cause price pressure effects as described in Barber and Odean (2008). Using data from 2004 to 2008, they document that increases in search frequency predict higher returns in the ensuing two weeks and an eventual reversal within the year.
Undiversified Stock Portfolios
Risk-averse investors should hold a diversified portfolio to minimize the impact of idio- syncratic risk on their investment outcomes.A fair bit of evidence suggests that many investors fail to effectively diversify idiosyncratic risk.
Investors who overinvest in the stock of their employer (company stock) are left exposed to the fortunes of that employer (idiosyncratic risk).
The proportion invested in company stock has declined over the past 10 years. According to the Employee Benefits Research Institute, in 1998 60% of recently hired employees invested in company stock.That figure dropped to 36% in 2009. Nonetheless, as of 2009, about 5% of participants had more than 80% of their account balances invested in company stock.
Barber and Odean (2000) document that, on average, investors in the LDB dataset hold only four stocks. Goetzmann and Kumar (2008) analyze the under- diversification of these investors in detail.They document that investors tend to hold portfolios that are highly volatile and consist of stocks that are more highly cor- related than one would expect if stocks were chosen randomly.