Who’s who among private investors?

15-07-14 10:31 | Markets and investments | Fredrik Wilander

Far from everybody actually saves, and of those who do only a fraction invests in stocks.

“The investor’s chief problem – and even his worst enemy - is likely to be himself”  Benjamin Graham

Today we know a great deal about the investment behavior of private individuals, both from Swedish and international research. One finding is that far from everybody actually saves, and of those who do only a fraction invests in stocks. This so called stock market participation puzzle has been widely studied and a conclusion is that the probability of participating in the stock market is positively correlated with income, education and financial literacy.

We also know that among those who do participate in the stock market, the investment behavior varies systematically across individuals, and for many the investment performance is far from stellar. Two researchers who have dug into this area are Brad Barber and Terrance Odean. Access to a large custumer database from an American online broker allowed the researchers in the studies Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors and  Boys will be boys: Gender, overconfidence and common stock investment  to make several interesting conclusions:

1. Private investors, in their sample, between 1991 and 1997 obtained an average return net of trading costs which was approx. 1.5 percentage points lower per year than the market return.

2. Investors with higher turnover did not have higher returns before trading costs compared to investors with lower turnover. However the difference in returns after trading cost between the 20 percent of the investors who had the largest turnover and 20 percent of the investors with the lowest turnover was almost 7 percentage points annually.

3. Small, high beta stocks were overrepresented in the portfolios (i.e. the risk was higher in the portfolios than for the market portfolio, thus the difference in risk-adjusted return was even greater)

4. Men have higher turnover than women, and also lower return after costs. The difference between men and women, both in terms of turnover and return, is higher for unmarried people. Young investors tend to have both lower returns and higher turnover compared to older investors and they tend to have riskier portfolios with both higher beta and higher firm-specific volatility. Young, unmarried men are therefore the worst investors!

Barber and Odean conclude that many private investors are overconfident in their ability to value investments differently than the market and therefore make too many transactions. The studies almost give the impression that the worst investors are more engaged with gambling than with long-term investments. This leads us to a more recent and very interesting study by Alok Kumar;  Who Gambles in the Stock Market?  published in 2009 in the Journal of Finance. Kumar notes that the probability of participating in a lottery is higher for certain people; men gambles more than women, young more than the old people, unmarried more than married and people with low education more than highly educated people. Kumar continues by showing that these socioeconomic factors also affect what type of equities private investors chose to invest in. He defines “lottery stocks” as stocks that have a low price (similar to a lottery ticket), high volatility and positive skewness in the return distribution (a small chance for a large positive return). Private investors favor “lottery stocks”, unlike institutional investors who underweight them. The size of the overweight in private portfolios is determined by the same factors that decide participation in lotteries.  Young, unmarried men hold the most risky “lottery” stocks. And again the returns are discouraging, especially risk-adjusted.

Concentrated portfolios of highly risky stocks that are traded frequently is obviously not an optimal investment strategy. A diversified portfolio containing both domestic and global firms is in our opinion a better approach. This leads us to a new research paper,  Who is Internationally Diversified?  by a group of researchers at Columbia Business School and a private research firm. Previous studies show that private investors have a home bias, i.e. a preference for the domestic market. This study, by examining the pension plans of US individuals, examines if the degree of home bias varies systematically between individuals, and find that it does. Gladly, we finally find a positive trait among younger savers – their international equity allocation, at least in their retirement savings, is higher. The same goes for individuals with higher education and higher financial literacy. A fun finding is also that individuals from states with higher international exports, as well as individuals living in areas with higher proportion of foreign-born population, also tend to have a larger share of international stocks in the portfolio. This seems intuitive.  An explanation for the observed home bias is that investors favor companies that they are familiar with. Often these are domestic firms and sometimes even from one’s own area. However, if one has foreign neighbors, there is a bigger probability of discussing foreign firms and investments while trimming the hedge.

To summarize; the investment behavior of private individuals varies substantially and systematically.  Many studies show that private investors do not invest optimally and that those most in need of making good investments also walk away with the lowest returns. Ultimately, as greater responsibility for one’s savings and financial future falls on the individual, these studies highlight the need for increasing financial literacy and for sound investment advice. 

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