Bezzled by Their Blind Spot
It’s sort of common knowledge that private investors generally lose by over-trading; invariably individuals think this only applies to other people and not to themselves, but you're just Bamboozled by Your Bias Blind Spot. The question remains, however, just how much do private investors lose by this behaviorally challenged frenzy of trading?
Figures are hard to come by, but one rule of thumb estimate suggests that US investors gave up $160 billion dollars in 2010 through this hyperactivity. Which is a nice boost for the denizens of the underpaid and underappreciated securities industry, struggling to keep their superyachts afloat.
So how do we come up with this number and what does it mean? Well, there’s no easy way of doing this calculation but we can do a bit of hopeful extrapolation to come up with a number to work with. In Just How Much Do Individual Investors Lose By Trading?, Brad Barber, Yi-Tsung Lee, Yu-Jane Lui and Terrance Odean analysed the Taiwanese market and showed that individual private investor losses equated to a 3.8% penalty on their performance, equivalent to a giant 2.2% of Taiwan’s GDP each year between 1995 and 1999.
Now the paper indicates that the equivalent trading losses in the US are about half of what was seen in Taiwan, around about 2%, so to come up with a rough and ready calculation of the annualised losses of US investors we need to know the cumulative value of their stock holdings. Fortunately, the 2010 US census provides us with a number: US households hold $8,147 billion in equities and 2% of this gives us $163 billion. This is roughly 1.1% of US GDP in 2010 and equivalent to $527 per head of population; man, woman and child.
Is this credible? Well, maybe. The original paper looks at data over a decade old, the estimate of the scale of US investor losses isn’t backed up by any solid evidence I can find and it’s not a valid assumption that all US equity holders are frenzied day traders riding a one-way ticket to oblivion. It also isn't a given that you can extrapolate from Taiwan to America –research suggests Chinese and Taiwanese investors are twice as confident about their abilities to beat the market as US investors.
On the other hand, we’ve since seen the rise of the internet and social media and ever escalating access to sources of information of variable quality which, as we shall see, serve to increase overtrading and private investor losses. In addition, although the scale of overconfidence in Chinese markets may be higher the general trend of behavioral bias is not. In any case, the point isn’t really whether or not this number is precise, but to come up with a rough estimate of the economic losses that private investors accrue through trend chasing. To which we can confidently say: it’s one heck of a lot.
The next question is – who benefits from this? As the paper above states:
“Our empirical analysis presents a clear portrait of who benefits from trade: Individuals lose, institutions win. While individual investors incur substantial losses, each of the four institutional groups that we analyze – corporations, dealers, foreigners, and mutual funds – gain from trade.”
Most, although not all, of individual investor losses were an effective transfer of wealth from themselves to institutions:
“Our empirical results suggest institutions profit in two ways. First, they provide liquidity to uninformed investors, thereby generating predominantly short-term profits. Second, they trade aggressively when they possess private information indicating prevailing market prices are misaligned. The profits from aggressive trading accrue over longer horizons, as the private information of institutions is gradually revealed to market participants.”
In the intervening years, of course, regulators have been running around attempting to level up the playing field, but the evidence is that they can’t keep up with the hugely better funded securities industry. We’ve seen the rise of high frequency trading (see Rise of the Machines and Fall of the Machines), the introduction of dark pools (Dark Pools and Adverse Selection) and now automated analysis of social media trends (Noise, Sentiment and Stock Twits): all of which gives wealthy institutions skewed and privileged access to the data needed to make informed trading choices. Usually this is justified on the grounds of improved liquidity, but this looks like a weak argument given the scale of the losses, even if you can figure out what it really means.
Private investors, on the other hand, have access to an increasingly varied range of babbling idiots, raising noise levels to the point where people who actually have done some proper analysis find it hard to make themselves heard. In Online Investors: Do the Slow Die First?, Barber and Odean find that after moving to online trading previously successful investors start losing:
“Those who switch to online trading perform well prior to going online, beating the market by more than 2% annually. After going online, they trade more actively, more speculatively and less profitably than before – lagging the market by more than 3% annually”.
Why, Oh Why?
So why does this happen? Why do private investors act like a bunch of baboons on a banana hunt in a warehouse full of inflatable bananas? Well, a clue can be gained from the sources of the losses:
“These losses can be broken down into four categories: trading losses (27%), commissions (32%), transaction taxes (34%), and market-timing losses (7%).”
It’s the trading and market-timing losses that equate to institutional gains, and the authors reckon that overconfidence is a major cause. The general impact of overconfidence on overtrading and consequent losses was set out in Odean and Barber’s original paper, Trading is Hazardous to Your Wealth, but is perhaps better described in Do the Slow Die First?:
“We posit that online investors become more overconfident once online for three reasons: the self-attribution bias, an illusion of knowledge, and an illusion of control”.
The self-attribution bias we’ve met before in the guise of the disposition effect – people attribute success to their own abilities and failure to factors outside of their control (see Disposed to Lose Money). The study finds that people start actively trading after they’ve had some success, which might trigger this change. The illusions of knowledge and control are behavioral findings around having access to more information – which generally doesn’t improve decision making, although we often think it does – and the additional confidence this engenders in us through the feeling that we’re in control through our powerful and purposeful mouse clicking (The Lottery of Stock Picking). Of course, we’re actually entirely at the mercy of events outside our control, which is why the mental dislocation when markets go mad can be so great, as investors struggle to handle the cognitive dissonance this creates.
Naturally, the marketing campaigns around the securities industry emphasise the need for investors to be quick, nimble and to seize every opportunity. The general problem is that the opportunities being seized are generally not ones you would want to go near in the short-term unless you’re particularly keen on handling poison ivy or wrestling an angry bear: information asymmetries in the market mean that if there is any real opportunity out there then it’s probably already been exploited by institutional investors. As Odean and Barber muse:
“Advertisments compare online trading to the old West, where the first to draw prevailed. Investors are led to believe that profitable investment opportunities are ephemeral events, seized only by the quick and vigilant. Most investors, however, benefit from a slow trading, buy-and-hold strategy. Trigger-happy traders are prone to shoot themselves in the foot”.
Of course, gunslingers of old generally preferred their targets to be unaware of their coming demise, preferably unarmed and, even more preferably, asleep. Lulling them into a false sense of security with a few shots of redeye was a darn good first step. When the bezzle is this big it’s worth investing in, but we don’t have to drink the gutrot.
In fact this isn’t really a bezzle – which is Galbraith’s term for the inventory of undiscovered embezzlement, but a febezzle, Charlie Munger’s idea of a legal form of monetary transfer in which no one thinks they’re doing anything wrong but in which their combined behavior is creating economic harm. Private investors are being legally febezzled, largely through their own efforts, and it’s high time we stopped it, even if we can't figure out exactly how much it's costing us.