The Behavior of Individual Investors

We cover five broad topics: the performance of individual investors, the disposition effect, buying behavior, reinforcement learning, and diversification. As is the case with any review paper, we will miss many papers and topics that some deem relevant. We are human, and all humans err. As is the case for individual investors, so is the case for those who study them.

1. The Performance Of Individual Investors

1.1 The Average Individual

In this section, we provide an overview of evidence on the average performance of individual investors. In Table 1, we provide a brief summary of the articles we discuss.
Collectively, the evidence indicates that the average individual investor underperforms the market-both before and after costs. However, this average (or aggregate) performance of individual investors masks tremendous variation in performance across individuals.

In research published through the late 1990s, the study of investor performance focused almost exclusively on the performance of institutional investors, in general, and, more specifically, equity mutual funds.1 This was partially a result of data availability (there was relatively abundant data on mutual fund returns and no data on individual investors). In addition, researchers were searching for evidence of superior investors to test the central prediction of the efficient markets hypothesis: investors are unable to earn superior returns (at least after a reasonable accounting for opportunity and transaction costs).

While the study of institutional investor performance remains an active research area, several studies provide intriguing evidence that some institutions are able to earn superior returns. Grinblatt and Titman (1989) and Daniel et al. (DGTW, 1997) study the quarterly holdings of mutual funds. Grinblatt and Titman conclude (p.415) “superior performance may in fact exist” for some mutual funds. DGTW (1997) use a much larger sample and time period and document (p.1037) “as a group, the funds showed some selection ability”.

In these studies, the stock selection ability of fund managers generates strong before-fee returns, but is insufficient to cover the fees funds charge.2 In financial markets, there is an adding up constraint. For every buy, there is a sell.

If one investor beats the market, someone else must underperform. Collectively, we must earn the market return before costs. The presence of exceptional investors dictates the need for subpar investors. With some notable exceptions, which we describe at the end of this section, the evidence indicates that individual investors are subpar investors.
To preview our conclusions, the aggregate (or average) performance of individual investors is poor. A big part of the performance penalty borne by individual investors can be traced to transaction costs (e.g. commissions and bid–ask spread). However, transaction costs are not the whole story. Individual investors also seem to lose money on their trades before costs.

The one caveat to this general finding is the intriguing evidence that stocks heavily bought by individuals over short horizons in the US (e.g. a day or week) go on to earn strong returns in the subsequent week, while stocks heavily sold earn poor returns. It should be noted that the short-run return predictability and the poor performance of individual investors are easily reconciled, as the average holding period for individual investors is much longer than a few weeks. For example, Barber and Odean (2000) document that the annual turnover rate at a US discount brokerage is about 75% annually, which translates into an average holding period of 16 months. (The average holding period for the stocks in a portfolio is equal to the reciprocal of the portfolios’ turnover rate.) Thus, short-term gains easily could be offset by long-term losses, which is consistent with much of the evidence we summarize in this section (e.g. Barber, Odean, and Zhu, 2009a).

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Individual Investors