A lot has been written on the madness of amateur investors thinking they can pick stocks better than the professionals.
And we’ve all seen the chart of investor psychology, which shows why people buy at the top and sell at the bottom.
But to really appreciate just how bad amateur investors are at stock-picking, consider the findings of a famous study by UC Berkeley’s Terry Odean. Here’s how it was described in Thinking, Fast And Slow by Daniel Kahneman:
Odean began by studying the trading records of 10,00 brokerage accounts of individual investors spanning a seven-year period. He was able to analyse every transaction the investors executed through that firm, nearly 163,000 trades. This rich set of data allowed Odean to identify all instances in which an investor sold some of his holdings in one stock and soon after bought another stock. By these actions the investor revealed that he (most of the investors were men) had a definite idea about the future of the two stocks: he expected the stock that he chose to buy to do better than the stock he chose to sell.
To determine whether those ideas were well founded, Odean compared the returns of the stock the investor had sold and the stock he had bought in its place, over the course of one year after the transaction. The results were unequivocally bad. On average the shares that individual traders sold did better than those they bought, by a very substantial margin: 3.2 percentage points per year, above and beyond the significant costs of executing the two trades.
If the average investor had any insight, the stocks he bought would outperform the stocks he sold.
If his picks were totally random — as if done by a chimpanzee throwing darts — then the stocks he bought would perform similarly to the ones he sold.
But in fact, the stocks bought by the average investor performed 3.2 per cent worse than stocks he sold.
And that’s not taking into account the cost of executing the trades. See, not only does the average investor trade better stocks for worse, but he also pays to do it.
Writes Kahneman: “It is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to mind.”