Investor behaviour comes at a cost
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Paul Resnik is a co-founder of FinaMetrica. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.
Many investors trade actively and speculatively to their detriment, according to a research paper, "The Behaviour of Individual Investors," by Brad M Barber from the University of California, Davis, and Terrance Odean from the University of California, Berkeley.
Investors would be better off investing consistently with their individual risk tolerance. This helps avoid unprofitable trading, which can markedly diminish investment performance over both the short and longer term.
If your portfolio is inconsistent with your risk tolerance, you're more likely to make emotional investment decisions when markets are volatile. The risk averse may sell down in a market correction; risk seekers may buy in during a market boom. Both add transaction costs, and generate profits and losses to manage for accounting and tax purposes.
They also leave the challenging question of when to re-enter or exit the market. Both are highly likely to diminish long-term portfolio returns. Your life choices will be reduced because there's less or even insufficient money available to meet your needs as they fall due.
So what are some of the factors that can so negatively influence your decision-making? According to the research paper, investors are influenced by the media.
"They tend to buy, rather than sell, stocks when those stocks are in the news. This attention-based buying can lead investors to trade too speculatively and has the potential to influence the pricing of stocks," the research paper says.
In addition, "investors are influenced by where they live and work. They tend to hold stocks of companies close to where they live and invest, at least in the USA, and in the stock of their employer. These behaviours arguably expose investors to unnecessarily high levels of idiosyncratic risk," the paper says.
Predictable, indeed! Investors often select companies based on what they read, rather than on what they research and analyse. So much so that they even prefer businesses located close by rather than ones with sound business plans and robust earnings growth and potential.
This leads to another downside of random investing: overtrading.
"Transaction costs are an unambiguous drag on the returns earned by individual investors. More surprisingly, many studies document that individual investors earn poor returns even before costs. Put another way, many individual investors seem to have a desire to trade actively coupled with perverse security selection ability," the paper says.