Weaselly SatisfiedThe idea that personal experience isn’t enough to help investors make better decisions is one we’ve investigated before; particularly in Investors Decisions – Experience Is Not Enough.
The general idea is that our personal observations don’t generalize, because market behaviour is continually adapting under evolutionary pressure.
Now recent research confirms this, up to a point. Which is a weasel-worded way of trying to convey the idea that I wasn’t exactly right but don’t want to admit it. Before we get all excited, however, the general idea still applies: experience helps, but only up to a point. And the point is very, very sharp and very, very expensive.
Maximilian Koestner, Steffen Meyer, and Andreas Hackethal in Do Individual Investors Learn From Their Mistakes? have picked up on the recent evidence that suggests investment performance does improve with experience. This, of course, isn’t the first time that a nice theory has been undermined by nasty data, but it’s a fascinatingly nuanced study. In essence, most of us get better, but only in certain ways. In others we remain as behaviorally challenged and frantically busy as ever.
On the positive side greater investment experience correlated with less trading – we turnover our portfolios less often. In the main over-trading is mostly associated with overconfidence (see: Overconfidence and Over Optimism) – we simply think we’re better at predicting the future than we actually are. This makes sense, because noting that we continually make mistakes in forecasting is the sort of the thing the averagely self-aware investor ought to notice, after enough losses.
This might also be an outcome of regret (see: Regret), where if we continually make investing errors of judgement the pain we experience will eventually cause us to trade less often. Remember that sins of commission – selling stuff that goes on to do well – hurt less that sins of omission – failing to buy stuff that does equally well. Reducing trading will tend to reduce the opportunities for experiencing regret: and there’s nothing quite as effective as pain as a learning mechanism (see: Of Mice and Templeton Moments).
Now if we can tie the reduction in overconfidence to an increase in trading experiences through a relatively simple learning mechanism we might equally expect that other behavioural biases which don’t lend themselves to similar cause and effect type relationships would be less impacted. This, it appears, is also the case because more experienced investors are still affected by the disposition effect and are still woefully underdiversified, at least according to the standard theories of portfolio management.
The disposition effect is our tendency to sell our winners and run our losers which is probably a side-effect of loss aversion (see: Disposed to Lose Money). We hate losses so much that we sell our winners to lock in our gains and we keep our losers in the hope of making back our losses. In general this is the wrong thing to do – losers tend to keep on losing and winners tend to keep on winning. Loss aversion is so powerful that it doesn’t seem to be greatly impacted by experience, although reducing overtrading will tend to reduce the frequency of such behaviour (see: Loss Aversion Affects Tiger Woods, Too).
Similarly underdiversification also isn’t reduced by experience. This would seem to be a straightforward failure of any direct learning mechanism. We have nothing to compare our underdiversified portfolios with so, unsurprisingly, we tend not to learn that we’re underdiversified (see: Diworsification is Good for You).
In fact Daniel Hirschleifer’s concept of self-enhanced transmission bias predicts exactly this (see: Facebook Friends Can Make You Poor). Active investors preferentially talk about their successful trades – which, of course, means that they need to a) trade a lot and b) pick a few highly risky stocks in order to generate something to boast about. The idea is that social interactions are a powerful driver of active trading, which would imply that we should see a lot of hyperactive trading.
Trade Too Much
Overall, the researchers opine:
“We conclude that compared to underdiversification and the disposition effect, it is relatively easy for individual investors to identify excessive trading activity, understand the nature and resulting costs of the mistake, and avoid it in the future.”
So let’s put this into perspective. The researchers analyse eight years worth of data from nearly 20,000 German retail investors. The average investor in the sample has a portfolio turnover of 16.2% per month, and the reduction caused by greater experience is 0.8%, which equates to 100 less trades. Personally I don’t think I turn over 16.2% of my portfolio per decade, but this corresponds with other studies that indicate eye-watering levels of trading, and equivalently high levels of charges (see: The 160 Billion Dollar Bezzle).
Of course each decision we make comes trailing clouds of uncertainty, and our biases tend to push us in the direction of losses rather than gains, so the more decisions we make the more likely we are to make mistakes. Reducing turnover has been shown to equate to returns that are more aligned with the market averages, but even this means that most people would be better off with an index tracker. Sadly boasting that you’ve just bought another slug of Vanguard isn’t going to generate much love amongst active traders.
Of course, the mechanisms described here are speculative, but the data’s quite convincing. Straightforward learning processes that link personal experience to behaviour changes will improve investor returns, but where the downsides of the behaviour are either not clear or are balanced by the apparent upside – the opportunity to demonstrate to your fellow traders what a fantastic stockpicker you are – then the outcome is more nuanced.
Well, actually, it’s not nuanced at all. Most investors should trade rarely, should sell their losers preferentially and should build a heavily diversified portfolio. The great value investor Ben Graham always had at least 25% of his investment funds in government bonds and usually ran with a portfolio of around 75 stocks. Diversification is the closest thing to a free lunch that the market offers, so it’s no surprise that active investors choose to ignore it in a quest for mutual appreciation from their counterparties.
For some people investing is as much about what other people think of them as what their returns are. Which is fine, if that’s your bag, but otherwise the best way of learning in investment markets is from other peoples’ research and experience. You’ll never learn enough from your own to really make a difference.
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