Many investors dedicate significant time to studying investments, tracking news and data, and learning technical analysis, only to see poor results. This can lead to self-doubt and thoughts of quitting the market. However, the problem might not be a lack of effort, but rather falling into common behavioral traps. This article will explore five such habits based on findings from a famous research report, "The Behavior of Individual Investors." Avoiding these pitfalls can lead to more stable and successful investing.
Individual Investors' Performance
Underperforming the Market
Research consistently shows that the performance of most individual investors lags behind the overall market in the long run. A study by Barber and Odeon revealed that U.S. retail investors achieve annual returns 1.5% lower than the market average. This doesn't even account for trading costs like commissions, price slippage, and taxes. The more frequently investors trade, the more likely they are to lose money, driven by a desire to control the market.
The Cost of Active Trading
The most active traders often have the worst performance. For example, the 20% of U.S. stock market investors who trade most actively have an average annual turnover of 258%. After deducting trading costs, their annual returns are significantly lower than those who follow a simple buy-and-hold strategy. This phenomenon isn't limited to the U.S. In Taiwan, research indicates that individual investors' annual trading losses can reach 2.2% of the country's GDP. The tendency to buy stocks that underperform and sell those that outperform contributes to this poor performance.
Key Factors in Underperformance
Frequent trading, poor stock selection, and high trading costs contribute to the underperformance of individual investors. While some skilled traders may achieve better results, most struggle to match or beat market averages.
The Disposition Effect
Selling Winners Too Early, Holding Losers Too Long
The "Disposition Effect" describes the tendency to sell winning stocks too quickly while holding onto losing stocks for too long. Research shows that retail investors exhibit this behavior across different countries. American investors are almost 50% more likely to sell profitable stocks than losing ones, while Chinese investors are 67% more likely. In Taiwan, investors are reportedly four times more likely to sell winners.
Psychological Drivers
This effect stems from a reluctance to face losses, as acknowledging them means admitting a wrong decision. Investors hold onto losing stocks in the hope of a rebound. Conversely, they are quick to secure profits from winning stocks. Psychological factors like regret avoidance and mental accounting contribute to this bias.
Attention-Driven Investing
The Lure of Popular Stocks
Investors are often drawn to stocks that are trending or frequently discussed in the news. Many purchase stocks not based on thorough research, but simply because they are popular at the moment. News reports, recommendations from friends, or mentions on search engine trending lists can trigger buying decisions.
Short-Term Gains, Long-Term Losses
While attention-grabbing stocks may experience short-term gains, research suggests they often lead to long-term losses. Increased search frequency might indicate higher returns in the short term, but a reversal tends to occur within a year. It's important to remember that chasing popularity doesn't equate to investment success.
Reinforcement Learning Behavior
Repeating Past Successes (and Failures)
Human nature leads individuals to repeat actions that have previously resulted in positive outcomes. If an investor makes money from a particular asset, they are more likely to buy it again, hoping to replicate the experience. Conversely, past losses with a certain stock can lead to avoidance, even if the stock now represents a sound investment opportunity.
The Danger of Emotional Investing
This emotionally driven behavior can be detrimental to long-term investment performance, as it hinders rational risk assessment. Over-allocating assets based on past performance can lead to significant losses in changing market conditions.
Insufficient Diversification
The Illusion of Spreading Risk
Many investors believe they are diversified simply by owning stocks from different companies. However, research suggests that the average shareholder holds only a few stocks, resulting in a concentrated risk profile. Over-investment in one's own company stock, local businesses, or familiar industries is a common problem.
Ignoring the Global Market
Furthermore, many investors neglect the international market, failing to invest in foreign ETFs, which can lead to a biased asset allocation. This "home bias" can result in significant return losses, potentially up to 5% annually. These losses can be avoided through low-cost, diversified index investing.
The Power of True Diversification
True diversification, similar to a structure with multiple support points, provides stability and reduces the impact of market fluctuations. Index investing, through ETFs, allows for comprehensive diversification and stabilizes assets.
Benefits of Index Investing
Index investing can mitigate many of the behavioral biases discussed. It reduces the disposition effect, as investments are mechanical. It minimizes attention-driven investing, as the focus is on a few diversified ETFs rather than individual popular stocks.