Blog - Investing Notes

October 31, 2005 – Classic Research: Can Individual Investors Consistently Excel?

We have selected for retrospective review a few all-time "best selling" research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the December 2002 paper entitled "Can Individual Investors Beat the Market?" (download count over 4,000) by Joshua Coval, David Hirshleifer and Tyler Shumway. This research investigates the persistence of outperformance and underperformance among individual investors/traders in stocks. Using data from a large discount broker on trades in 115,856 accounts during 1/90 through 11/96, they conclude that:

• There is significant persistence in the trading performance of individual investors.
• The trades of the top 10% of investors/traders outperform on average by a risk-adjusted 12-15 basis points per day during the ensuing week.
• The trades of the bottom 10% of investors/traders underperform on average by a risk-adjusted 11-12 basis points per day during the ensuing week.
• Outperformance or underperformance is more a matter of stock selection than market timing.
• A rolling strategy with one-week holding periods of going long on stocks purchased by successful investors and shorting stocks purchased by unsuccessful investors yields excess returns of 5 basis points per day (13.7% per annum).

In summary, skillful individual investors exploit market inefficiencies to earn abnormal profits, above and beyond those available from well-known strategies based upon firm size, value or momentum.

For summaries of related research on individual investing/trading, see our blog entries of:

9/29/05 for a rigorous luck-or-skill analysis of Warren Buffet's investing track record;

9/6/05 investigating wealth transfer between individuals and institutions in financial markets;

8/10/05 on individuals as suboptimizing "little-picture" traders;

6/21/05 regarding the (underperforming) tendency of individuals to buy attention-grabbing stocks;

5/11/05 analyzing mutual funds as passive vehicles through which active individual investors voluntarily transfer wealth to public corporations;

3/16/05 finding that undiversified does not mean underperform for risk-tolerant individual investors with relatively large accounts;

2/6/05 examining the counterplay between active individual investors and rational speculators (smart traders) after attention-grabbing events;

10/29/04 on the significant underperformance of individuals who trade actively; and,

10/22/04 investigating whether day-traders make money.