Social Science Research Network’s Brad M. Barber and Terrance Odean provide an overview of research on the stock trading behavior of individual investors. This research documents that individual investors (1) underperform standard benchmarks (e.g., a low cost index fund), (2) sell winning investments while holding losing investments (the “disposition effect”), (3) are heavily influenced by limited attention and past return performance in their purchase decisions, (4) engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain, and (5) tend to hold undiversified stock portfolios. These behaviors deleteriously affect the financial well being of individual investors.
The bulk of research in modern economics has been built on the notion that human beings are rational agents who attempt to maximize wealth while minimizing risk. These agents carefully assess the risk and return of all possible investment options to arrive at an investment portfolio that suits their level of risk aversion. Models based on these assumptions yield powerful insights into how markets work. For example, in the Capital Asset Pricing Model—the reigning workhorse of asset pricing models—investors hold well-diversified portfolios consisting of the market portfolio and risk free investments. In Grossman and Stiglitz’s (1980) rational expectations model, some investors choose to acquire costly information and others choose to invest passively. Informed, active, investors earn higher pre-cost returns, but, in equilibrium, all investors have the same expected utility. And in Kyle (1985), an informed insider profits at the expense of noise traders who buy and sell randomly.
A large body of empirical research indicates that real individual investors behave differently from investors in these models. Most individual investors hold underdiversified portfolios. Many apparently uninformed investors trade actively, speculatively, and to their detriment. And, as a group, individual investors make systematic, not random, buying and selling decisions.
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Transaction costs are an unambiguous drag on the returns earned by individual investors. More surprisingly, many studies document that individual investors earn poor returns even before costs. Put another way, many individual investors seem to have a desire to trade actively coupled with perverse security selection ability!
Unlike those in models, real investors tend to sell winning investments while holding on to their losing investments—a behavior dubbed the “disposition effect.” The disposition effect is among the most widely replicated observations regarding the behavior of individual investors. While taxes clearly affect the trading of individual investors, the disposition effect tends to increase, rather than decrease, an investor’s tax bill since in many markets selling winners generates a tax liability that might be deferred simply by selling a losing, rather than winning, investment.
Real investors are influenced by where they live and work. They tend to hold stocks of companies close to where they live and invest heavily in the stock of their employer. These behaviors lead to an investment portfolio far from the market portfolio proscribed by the CAPM and arguably expose investors to unnecessarily high levels of idiosyncratic risk.
Real investors are influenced by the media. They tend to buy, rather than sell, stocks when those stocks are in the news. This attention-based buying can lead investors to trade too speculatively and has the potential to influence the pricing of stocks.
With this paper, we enter a crowded field of excellent review papers in the field of behavioral economics and finance (Rabin (1998), Shiller (1999) Hirshleifer (2001), Daniel, Hirshleifer, and Teoh (2002), Barberis and Thaler (2003), Campbell (2006), Benartzi and Thaler (2007), Subrahmanyam (2008), and Kaustia (2010a)). We carve out a specific niche in this field—the behavior of individual investors—and focus on investments in, and the trading of, individual stocks. We organize the paper around documented patterns in the investment behavior, as these patterns are generally quite robust. In contrast, the underlying explanations for these patterns are, to varying degrees, the subject of continuing debate.
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