In 2017, 54% of American households held stocks (Gallup). Stock trading is a pervasive activity in our society and scholars have devoted a great effort in recent years to studying them. Giovanni Burro is one of these scholars. How would he describe individual trading activities? One word comes to his mind: messy. Individual traders are characterized by a mix of naivety and overconfidence. Men in particular, are a bit like Tarzan. Although now located in the middle of Times square. They are strong and confident, but they end up being lost. On top of that, they are a bit like those (many) Italians who constantly look for Italian food when they are abroad. Most of the times they end up being disappointed by some crunchy pizza or overcooked Alfredo fettuccine. Giovanni will talk you through investors’ behaviour in the stock market and will tell you where it all goes wrong.
Performance of individual households in the stock market is quite disappointing (for them). In general, they heavily underperform compared to the market and they show perverse stock selection abilities. They trade too much and they tend to have overconcentrated portfolios. Overconcentrated portfolios imply a higher risk. In finance an overconcentrated portfolios just means you have “put all your eggs in one basket.” If your basket falls, all eggs crack. You’d better put some of your eggs in different baskets in order to differentiate risks.
Let’s start from these concentrated portfolios. Financial models urge investors to differentiate the risk they bear. Investors, on the other end, tend to overweight stock in their industry and geographical area. Why is this wrong? It can end up being a double-whammy. Imagine you worked in the car industry. Imagine, the car industry suffered dramatically. You might lose your job. Better you do not hold stocks of companies in your industry. It would only make your situation worse, given that you are already in trouble. Similarly, imagine you were Greek during the Euro crisis. In that period, you might have experienced serious financial troubles because of the situation of your country (no job, increased taxes, no access to credit). Having Greek stocks (or bonds) in your portfolio would have been the icing on the cake.
Individual investors fail to respect this simple rule. It might be that they hold too few stocks because of the mental burden of managing a big portfolio and continuously updating information on all of their stocks. However, the fact they invest in stocks which are familiar to them (because of industry or location) is probably due to the fact they feel more comfortable in investing into them. But I just explained why this is a bad idea. We feel more comfortable buying these stocks because we feel more comfortable, because we feel more knowledgeable about our industry and our region. However, this often just backfires.
A final caveat on this point is represented by some debated evidence on profitability of that strategy. Without dipping into all the mathematical details, there are some authors who claim that investors with concentrated portfolios have higher returns than others. That would be due to informational advantages since it is true for local stocks and stocks not included in the S&P 500 index (the index of the biggest American companies). The bottom line is: to reduce risk do not invest in stocks whose value is correlated to your wealth in other domains. Keep in mind that this is a general rule. If the CFO of the multinational, multimillion company next door to you, is your BFF from high school, you might think twice before following this suggestion.
Even when taking into account overconcentrated portfolios, individual households tend to have widespread bad performance. There are two more intriguing reasons I can discuss: overconfidence and sensation-seeking.
Let’s start with sensation-seeking. It could be that investors trade to feel their spine tingle. Trading can be a very emotional and exciting activity and there is some evidence that people who look for other forms of excitement trade more. Then, making money would not necessarily be the main goal for their activity. Losing money could be the same as paying a (really expensive) fee for some rollercoaster. To exemplify: trading activity is associated with speeding tickets, overconfidence and lotteries (observed in Taiwan and the US). Those are all activities related to excitement and thrill. Moreover, in periods when a really high jackpot in some very popular lotteries was available, trading activity decreased considerably. In particular, trading volume on the so-called lottery stocks (stocks which can easily give very high or very low returns) was affected, backing up the idea that some investors mainly trade to gamble and to experience excitement.
Finally, let’s look at overconfidence. In general, investors trade too much, to their own detriment. Trading a lot correlates with impulsive decision-making, bad performance but also to high(er) transaction costs. There is solid evidence that overconfidence leads to bad decisions in the stock market, and this is not the only domain it affects. It has been shown that men tend to be more prone to overconfidence than women in areas culturally perceived to be in the male domain. Trading is one of those (probably). Men trade more than women and perform worse. Trading a lot can be interpreted as a signal of overconfidence. In general, active (read: overactive) traders perform worse than inactive. Finally, German investors who deem themselves as more knowledgeable trade more aggressively, because they feel that they have an “edge” on their competitors.
To sum up, households make several mistakes when they invest their money. Here, we summarized only some of them. The take home for now is: go check your investments and if you hold too many stocks of companies in your own sector or region (even worse, the company where you work!) maybe consider selling them. Then, sit back, relax, and avoid trading too often. If you really want to feel some excitement go see a horror movie, go bungee jumping or just take a walk around some small UK village shouting “I love the EU”. Excitement guaranteed.
References: Odean, Terry and Barber, Brad (2013). The behavior of individual investors. Handbook of the Economics of Finance, 22, 1533-1570.