We’re only human – and that’s not good for stock investors. Studies have shown that we’re overconfident in our ability, speculate too much, don’t diversify enough, and a few hundred other self-defeating flaws. BehavioralFinance.net has a long list of our shortcomings as investors.
Humans also have a remarkable ability to overcome handicaps. We can change. We can make ourselves better and become better investors, but we can’t fix all our flaws at once. That’s why a recent study conducted by four academics from Goethe University Frankfurt is interesting. The group isolated two specific bad behaviors that hurt investor returns most.
Which Investment Behaviors Really Matter for Individual Investors? by Joachim Weber, Steffen Meyer, Benjamin Loos, and Andreas Hackethal is an interesting read. This research focused on determining which type of behavior is most associated with negative returns and to what degree.
The research covered 13 years of data for 5,000 individuals who invested through a European discount brokerage firm. Their stock selection performance was compared against 10 measures of investment behavior. They included the following (pardon the trade lingo):
- Portfolio turnover: unprogrammed trading volume scaled by portfolio value.
- Trade clustering: clustering of investor trades in time.
- Disposition effect: selling of winners and holding of losers.
- Leading turnover: trading before other investors (same security/same direction).
- Forecasting skill: systematically realizing excess returns on purchased securities.
- Trend following: buying funds with recent increases in value.
- Home bias: preference for German stocks or Germany-focused funds.
- Local bias: preference for stocks/funds with nearby headquarters.
- Lottery mentality: preference for stocks with low price and high idiosyncratic volatility/skewness.
- Under-diversification: holding only a few securities and/or highly correlated securities.
While all 10 behavioral flaws reduced investor returns somewhat, only lottery mentality (#9) and under-diversification (#10) were significantly related to economically large shortfalls in return for stock investors. Eliminating just these two investment behaviors would improve the average stock investor’s returns relative to other investors in the same study by 3% for the lottery mentality and 4% for under-diversification.
In my opinion, the real message in the research is to forgo buying individual stocks as a way to invest. It’s difficult enough to try to pick the right companies, let alone all of the emotional baggage that comes along with managing a stock portfolio.
A better approach is to buy broad-based low-cost equity index funds instead. A total stock market index fund eliminates a lottery mentality and under-diversification issues because it owns thousands of securities. Take a look at the Vanguard Total Stock Market Index Fund (ticker: VTSMX) as an example. The fund holds over 3,600 securities and as of August 12, 2013 had an expense ratio of only 0.17%. Lower cost Admiral and exchange-traded fund (ETF) share classes are only 0.05%. VTSMX is just one of many low-cost index funds and ETFs on the market today.
Selecting individual stocks is difficult enough without the emotional biases and other behavioral problems that follow. Avoid the pitfalls of chasing returns and under-diversification by purchasing a low-cost index fund or ETF. It’s the smart way to invest.