A Little Investment Horse Sense
All the information in the world might not make an investor any richer. In fact, it may make one poorer. The notion is contrary to the prevailing wisdom that markets won't be fully democratized until all investors have equal access to timely and reliable information. But study after study shows that investors don't always behave rationally about money, or act in their own best interests, especially when they think they know what they're doing.
A study of horse-race handicappers, done in the late 1970s, seems particularly relevant for stock investors today. The University of Oregon did a study in which 17 handicappers were asked to predict the outcome of races already won. Information about the horses was doled out incrementally, each time asking the handicappers to predict the winner and to note their confidence in the predictions. This study found that as the amount of information increased, confidence also increased, but the accuracy of the predictions did not.
The difficulty, according to the University, lies in integrating many pieces of information garnered from more than 11,000 personal finance Web sites - all competing for the investors' attention. The more there are, the more material you have for a meaningful picture - and the more pieces of information that only look as if they belong to the investment puzzle. The message derived from this study shows that when it comes to investing, feelings of confidence are not trustworthy.
And yet another academic study shows clearly that confident investors trust themselves to make important decisions, such as how to allocate assets, or what, and how often, to trade. The Graduate School of Management at the University of California - Davis, has studied tens of thousands of discount-brokerage accounts, gleaning two simple truths: First, overconfident investors trade excessively, and, second, frequent trading is not a profitable strategy.
Proof that traders are overly confident comes from the surprising fact that on average, the stocks that they purchased actually underperformed the stocks that they sold to buy them. Needless to say, the gains that they thought they would realize through trading did not even cover the costs of the trade. Analysis of some 60,000 accounts found that the traders who were most active netted an average return of just 9.6% annually, compared with 15.3 percent for the average discount-brokerage investor and 17.1 percent for the market benchmark.
A study by academics who specialize in the fairly new field of behavioral finance, found that mutual fund investors also were overly optimistic and overconfident. Their portfolios reflected as much. The researchers surveyed 1,053 subscribers to the Mutual Fund Web site Morningstar.Net and found that 39 percent of investors spent much more time thinking about the potential for positive returns than they spent considering possible losses; only 3 percent did the reverse. One third thought stocks would always outperform bonds over the long term. Those investors put 84 percent of their retirement savings into stocks. While history shows that stocks do outperform bonds much of the time, they certainly don't do so all the time.
Overconfidence, not the lack of data, is the biggest danger faced by all investors. And how is it that investors become overconfident in the first place? By enjoying successes early on, and by taking too much credit for them, instead of giving luck and the bull market their due!
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A study of horse-race handicappers, done in the late 1970s, seems particularly relevant for stock investors today. The University of Oregon did a study in which 17 handicappers were asked to predict the outcome of races already won. Information about the horses was doled out incrementally, each time asking the handicappers to predict the winner and to note their confidence in the predictions. This study found that as the amount of information increased, confidence also increased, but the accuracy of the predictions did not.
The difficulty, according to the University, lies in integrating many pieces of information garnered from more than 11,000 personal finance Web sites - all competing for the investors' attention. The more there are, the more material you have for a meaningful picture - and the more pieces of information that only look as if they belong to the investment puzzle. The message derived from this study shows that when it comes to investing, feelings of confidence are not trustworthy.
And yet another academic study shows clearly that confident investors trust themselves to make important decisions, such as how to allocate assets, or what, and how often, to trade. The Graduate School of Management at the University of California - Davis, has studied tens of thousands of discount-brokerage accounts, gleaning two simple truths: First, overconfident investors trade excessively, and, second, frequent trading is not a profitable strategy.
Proof that traders are overly confident comes from the surprising fact that on average, the stocks that they purchased actually underperformed the stocks that they sold to buy them. Needless to say, the gains that they thought they would realize through trading did not even cover the costs of the trade. Analysis of some 60,000 accounts found that the traders who were most active netted an average return of just 9.6% annually, compared with 15.3 percent for the average discount-brokerage investor and 17.1 percent for the market benchmark.
A study by academics who specialize in the fairly new field of behavioral finance, found that mutual fund investors also were overly optimistic and overconfident. Their portfolios reflected as much. The researchers surveyed 1,053 subscribers to the Mutual Fund Web site Morningstar.Net and found that 39 percent of investors spent much more time thinking about the potential for positive returns than they spent considering possible losses; only 3 percent did the reverse. One third thought stocks would always outperform bonds over the long term. Those investors put 84 percent of their retirement savings into stocks. While history shows that stocks do outperform bonds much of the time, they certainly don't do so all the time.
Overconfidence, not the lack of data, is the biggest danger faced by all investors. And how is it that investors become overconfident in the first place? By enjoying successes early on, and by taking too much credit for them, instead of giving luck and the bull market their due!
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posted by Bob Moser at
6:22 PM
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