What Is the Performance of Individual Investors in Stock Markets?

Case study 1

Q1: What is the performance of individual investors in stock markets?

Collectively, the evidence indicates that the average individual investor underperforms the market—both before and after costs. Individual investors are subpar investors and have tremendous variation in performance. Thus, the aggregate (or average) performance of individual investors is poor. A big part of the performance penalty borne by individual investors can be traced to transaction costs. However, transaction costs are not the whole story. Apart from this, individual investors have different performance in long and short runs.

• Individual investors also seem to lose money on their trades before costs. stocks heavily bought by individuals over short horizons in the US (e.g. a day or week) go on to earn strong returns in the subsequent week, while stocks heavily sold earn poor returns. It should be noted that the short-run return predictability and the poor performance of individual investors are easily reconciled, as the average holding period for individual investors is much longer than a few weeks. For example, Barber and Odean (2000) document that the annual turnover rate at a US discount brokerage is about 75% annually, which translates into an average holding period of 16 months. (The average holding period for the stocks in a portfolio is equal to the reciprocal of the portfolios’ turnover rate.)
• Short-term gains easily could be offset by long-term losses. Apart from this, Contrary to the long-run above, the returns earned by individual investors over short horizons (up to a week) appear to be quite strong. People document that the stocks bought in aggregate by individuals in the 10 days prior to an earnings announcement outperform those sold in aggregate by about 1.5% in the two days around the earnings announcement. They argue liquidity provision and private information contribute equally to the strong returns earned by individuals around earnings announcements.

In summary, the performance in long-horizon is poor, and contrary to the long-run, the short horizon is quite strong.

Q2: Why do individual investors underperform?

Transaction costs are an important component of the shortfall; a second component is the poor security selection ability of individual investors. There are four main reasons that can explain why the individual investors underperformed.

• At the first, Asymmetric Information is one of it, investors realize that they are at an informational disadvantage when trading and only do so for non-speculative reasons including liquidity needs, rebalancing, and taxes. Investors may need to purchase stocks to save, or sell stocks to consume. At times, investors may need to rebalance their portfolios to manage risk-return tradeoffs. Occasionally, investors will want to harvest tax losses to minimize their tax bill. When faced with these liquidity, rebalancing, or tax management needs, retail investors are forced to trade with others who might be better informed.
• Secondly, overconfidence can explain the relatively high turnover rates and poor performance of individual investors, and a fair amount of evidence indicates that the better-than-average and overestimation varieties of overconfidence are correlated with higher levels of trading by investors. While the evidence that miscalibration is linked to trading is weaker, we suspect this weak link might be partially explained by the current inability to measure miscalibration well.
• In addition, Sensation Seeking, which means individual investors is the simple observation that trading is entertainment and appeals to people who enjoy sensation seeking activities such as gambling; or some people have a taste for stocks with lottery-like payoffs.
• As for familiarity, some people believe that investors are better informed about the prospects of such companies and that this information advantage leads to superior investment performance. But the truth is the performance implication of investing in geographically or occupationally familiar stocks is the subject of ongoing debate. However, investors overweight these stocks in their equity portfolios, which has potentially important implications for diversification.

Q3: How can individual investors win a good return in the market?

In theory, investors supposed to hold well-diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. But in practice, trading frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses; and holding poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience. So as an individual investor, people need to know what makes investor do a poor performance in the market. To specific, Asymmetric information, overconfidence, sensation seeking and familiarity are the reasons why individual cannot win a good return in the market. At last, individual investors who follow the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do win a good return.