Which 2 Investment Behaviors Are Most Associated With Negative Returns & to What Degree?

Which type of behavior is most associated with negative returns and to what degree? This article isolates 2 specific bad behaviors that hurt investor returns most and recommends how such shortcomings can easily be avoided.

So writes Rick Ferri in edited excerpts from an article* posted on advisoranalyst.com entitled Two Behaviors That Hurt Stock Investors.

[The following is presented by Lorimer Wilson, editor of www.munKNEE.com and  may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]

Ferri goes on to say in further edited excerpts:

…A recent study (Which Investment Behaviors Really Matter for Individual Investors) conducted by four academics from Goethe University Frankfurt (Joachim Weber, Steffen Meyer, Benjamin Loos, and Andreas Hackethal)… focused on determining which types of behavior are most associated with negative returns and to what degree and isolated two specific bad behaviors that hurt investor returns most.

The research covered 13 years of data for 5,000 individuals who invested through a European discount brokerage firm. Their stock selection performance was compared against 10 measures of investment behavior. They included the following (pardon the trade lingo):

1. Portfolio turnover: unprogrammed trading volume scaled by portfolio value.
2. Trade clustering: clustering of investor trades in time.
3. Disposition effect: selling of winners and holding of losers.
4. Leading turnover: trading before other investors (same security/same direction).
5. Forecasting skill: systematically realizing excess returns on purchased securities.
6. Trend following: buying funds with recent increases in value.
7. Home bias: preference for German stocks or Germany-focused funds.
8. Local bias: preference for stocks/funds with nearby headquarters.
9. Lottery mentality: preference for stocks with low price and high idiosyncratic volatility/skewness.
10. Under-diversification: holding only a few securities and/or highly correlated securities.

The results:

Only

• lottery mentality (#9) and
• under-diversification (#10) significantly…

affected the average stock investor’s returns (relative to other investors in the same study) – by -3% and -4% respectively.

In my opinion, the real message in the research is to:

1. forgo buying individual stocks as a way to invest (it’s difficult enough to try to pick the right companies, let alone all of the emotional baggage that comes along with managing a stock portfolio) and
2. buy broad-based low-cost equity index funds instead (a total stock market index fund eliminates a lottery mentality and under-diversification issues because it owns thousands of securities [and has a lower management expense ratio (MER) associated with it].

Conclusion

Selecting individual stocks is difficult enough without the emotional biases and other behavioral problems that follow. Avoid the pitfalls of chasing returns and under-diversification by purchasing a low-cost index fund or ETF. It’s the smart way to invest.

*http://www.advisoranalyst.com/glablog/2014/02/14/two-behaviors-that-hurt-stock-investors.html (Copyright 2007 – 2013 AdvisorAnalyst.com / All rights reserved)

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