Michael looks at several academic studies covering retail investors and what we can learn from them.
We last looked at an academic article on trading in the summer of 2020.
For a refresher, there were several findings.
1. “Retail investors tend to trade as contrarians after large earnings surprises, both positive and negative”
Retail investors typically love to buy stocks with profit warnings – the old catching a falling knife trade.
They are also quick to book profits on stocks with earnings surprises to the upside.
This is why “cut your losses and run your winners” is an oft-used phrase. It’s the exact opposite of what the study in the article found retail investors do.
2. Contrarian trading behaviour did not appear to be information-driven on average
The study found that most retail investors were doing their trading post announcement. Rather than taking a view on the stock before the announcement, they were reacting to the surprise (and often as a contrarian).
3. Contrarian behaviour appeared to be attention related
Retail investors were more likely to trade as contrarians more intensely on stocks they held.
I believe this is because many retail investors are risk-averse. Rather than cutting their losses, they preferred to take on more risk rather than admit they were wrong.
I think this because many of these portfolios that were looked at had significant negative returns compared to the market by going against momentum.
And finally, a key learning:
4. The small number of stocks in each account coupled with the relative infrequency of announcements may prevent retail investors from learning that their trading behaviour is sub-optimal
This part of the study I didn’t agree with. If every time you trade you lose money, it doesn’t take being Warren Buffett to realise that what you’re doing is wrong. But this was a suggestion of the research.
You can read the full article here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3544949
Review of existing literature and findings
Barber and Odean (2000)
There have been plenty of studies published on retail trading.
Barber and Odean (2000) found that in a study of 78,000 households in a large discount brokerage firm between 1991 and 1996 that there was evidence suggesting that overconfidence leads to excessive trading.[1]
The data is somewhat dated but I’ve learned from my own experience that my biggest losses have come after my biggest wins.
Barber and Odean also found that there was little different business between the gross performance of households that trade frequently and those that trade infrequently. However, they did find that there was a significant difference in returns due to commissions and fees.
Given that the sample is from 1991 to 1996 we can assume that the discount brokerage fees were likely higher than they are today given payment for order flow models such as Robinhood, but trading commissions are a real drag on performance on small accounts.
For example, let’s say you’re charged £8 per trade (a realistic price today). With a trade size of £1,000, you’re looking at 1.6% churn based entirely from commission.
If you make 50 round-trip trades (one buy and one sell) on a £1,000 position, then you’ll have spent £800 on commission. It’s not an insignificant sum. And that’s not including the spread on each trade as a hurdle.
Ivkovic and Weisbenner (2005)
Ivkovic and Weisbenner (2005) found that individuals outperform the market when they buy stocks that operate close to their homes compared to other stocks.[2]
This suggests evidence that there not only is there a benefit to having an ear closer to the ground but an edge that can be gained too.
How many retail investors are buying shares of mines in faraway lands that they have no idea about?
And how many Newcastle-based investors profited from Greggs’ shares?
That said, many Yorkshire-based investors also lost heavily in their investments in Sirius Minerals. So, an edge is not by any means guaranteed.
Sicherman et al. (2015)
Sicherman et al. (2015) found that daily logins from retail investors fell by 9.5% after market declines and investors pay less attention to the market when volatility is high.
This goes against new evidence in 2020 and 2021 when there was an influx of new investors from Covid. However, the circumstances were different here, as people found themselves not being able to spend with lots of surplus cash, which they invested (or gambled – you choose) in the market.
I have found as a general rule on Twitter that many investors are happy to post their returns when everything is going well, and activity on Twitter seems to diminish when markets are tough.
Quespe-Torreblance et al. (2020)
Quespe-Torreblance et al. (2020) found retail investors devote disproportionate attention already-known positive information about individual stocks they own and an aversion to paying attention to unfavourable information.[3]
This is consistent with the information aversion bias, which suggests investors try to explain away or try to ignore bad news on their holdings. I call this “ostriching”, where investors bury their heads in the sand and do nothing.
Conclusion
Academic research on trading shouldn’t be taken as irrefutable proof. Remember, most academics have never made a penny in the market and don’t understand the stock market.
After all, it was an academic that won a Nobel Prize for the efficient market hypothesis. Markets are run by fear and greed, and this is unlikely to change anytime soon.
You also need to look at the dates from the study and ask if anything has changed. Maybe the study is still relevant or maybe it’s from a different era (for example, the discount brokers in 1991-1996).
But reading academic studies to see how retail investors act or have acted in the past can help to highlight some of your own flaws and give you an idea of how to negate them.
Michael Taylor
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Twitter: @shiftingshares
- Barber B.M., Odean T. Trading is hazardous to your wealth: the common stock investment performance of individual investors. J. Finance. 2000;55:773–806. ↑
- Ivkovic Z., Weisbenner S. Local does as local is: information content of the geography of individual investors’ common stock. J. Finance. 2005;60:267–306. ↑
- Quispe-Torreblanca E., Gathergood J., Loewenstein G., Stewart N. Attention utility: evidence from individual investors. 2020. ↑
