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Overview of Research on Individual Investors

July 7, 2011 • Posted in Animal Spirits, Individual Investing

What does the body of academic research say about the stock trading behaviors and outcomes for individual investors? In their June 2011 paper entitled “The Behavior of Individual”, Brad Barber and Terrance Odean survey four areas of empirical research on the behavior of individual investors trading individual stocks: (1) performance, (2) the disposition effect, (3) buying behavior and (4) diversification. Using the findings of many studies performed over the last three decades, they conclude that:

  • On average, individual investors perform poorly. While this underperformance is due largely to trading frictions (commissions and bid-ask spread), individual investors appear to lose money on trades even before frictions. However, there is:
    • Evidence contrary to this general finding that U.S. stocks bought (sold) intensely by individuals over short intervals of a day or week tend to outperform (underperform) the next week.
    • Strong evidence of variation in trading performance among individuals. However, security selection skill is rare, and even the best stock pickers have trouble covering trading frictions.
  • Individual investors strongly exhibit the disposition effect, a counterproductive tendency to sell winners and hold losers, with the tendency most pronounced among financially unsophisticated investors.
  • There is some evidence that limits to attention cause individual investors to overreact (underreact) regarding stocks in the news (not in the news).
  • There is evidence that individual investors fail to adequately diversify their stock portfolios by concentrating in their employer’s stock, local stocks, familiar stocks and domestic stocks.

In summary, the body of evidence suggests that individual stock investors tend to underdiversify and overtrade, thereby incurring relatively high volatility, trading frictions and taxes and thus realizing relatively poor performance.

Perhaps because of broker interests and individual privacy issues, studies of the kind reviewed tend to involve limited targets of opportunity with regard to sample breadth (a single broker) and duration.

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