Brad Barber and Terrance Odean have produced a series of landmark studies on the performance of individual investors, demonstrating that they persistently fail to achieve the returns provided by the market.
They found this underperformance holds true for men and women, though women outperform men because they trade less. It applies to investment clubs as well, proving that more heads aren’t necessarily better than one. Investment clubs also tended to underperform both individual men and women. Barber and Odean further demonstrated that not all of the poor performance was due to excessive trading. They found that individuals exhibit perverse stock selection skills, meaning the stocks they purchase tend to underperform the market after they buy them and the stocks they sell tend to outperform after they are divested.
Russell Jame and Qing Tong — authors of the study “Industry-Based Style Investing,” which appears in the June 2014 issue of the Journal of Financial Markets — contribute to our understanding of individual investors and their underperformance. Their study, which covered the period 1983-2000, sought the answer to three questions:
Do retail investors herd into and out of certain industries?
How does retail investor industry demand impact stock prices?
To what extent is the poor performance of retail investor trading driven by their industry-wide investment decisions?
The following is a summary of their findings.
Do Retail Investors Herd?
After controlling for size and book-to-market, retail investors do indeed herd. They follow each other into and out of the same industries. Industry demand cannot be explained by retail investors following each other into and out of the same stock or stocks with similar market caps or book-to-market ratios. Consistent with evidence that individuals are performance chasers, retail investors tend to chase industries that have performed well over the past two years and they tend to sell the poor performers.
Does Retail Investor Demand Impact Prices and Returns?
The retail investor industry proportion of stocks bought over the prior week positively forecasts industry returns over the subsequent week. A portfolio that went long in the industries most heavily bought by retail investors in the prior week and short in the industries most heavily sold by retail investors — and rebalanced weekly — would earn a market-adjusted return of 72 basis points per month. Even after adjusting for the Fama-French factors, the alpha is 64 basis points per month. Of course, this is a very high turnover strategy — real world results would look quite different.
The correlation between retail investor industry demand in the current week and retail investor industry demand in the prior week is more than 60 percent, and it is statistically significant. The correlation gradually declines over time.
The retail investor industry proportion of stocks bought over the prior quarter, six months, or year negatively forecast industry returns over the subsequent quarter, six months or year.
A portfolio that went short in the value-weighted quintile of industries most heavily bought over the prior quarter and long in the value-weighted quintile of industries most heavily sold in that quarter would earn an average abnormal return of 41 basis points per month over the subsequent quarter. The results are statistically significant at the 1 percent level, even after adjusting for the Fama-French factors. Results are similar for six-month and one-year horizons.
Is Their Poor Performance Driven by Industry-wide Investment Decisions?
Stocks in industries heavily bought by retail investors continue to significantly underperform stocks in industries heavily sold by retail investors. Stocks in industries that were heavily bought over the past 6 months earn abnormal returns of -28 basis points per month, while stocks in industries that were heavily sold outperform by 20 basis points per month, and the difference of 48 basis points is highly significant.
While the authors confirmed prior research demonstrating that individual investors do exhibit perverse stock selection skills (the stocks they buy go on to underperform and the stocks they sell go on to outperform) they additionally found that industry selection is responsible for more than 60 percent of the previously documented poor performance. They write, “industry-wide sentiment has an effect on asset prices that is distinct from firm-specific sentiment.”
Another interesting finding was that retail investors tend to be firm-level contrarians over short horizons, but firm-level momentum traders over longer horizons. Unfortunately, momentum is a short-term phenomenon, and over the long-term we tend to see mean reversion.
Among the 77 mistakes covered in my book, “Investment Mistakes Even Smart People Make and How to Avoid Them,” is that of “recency.” Recency is the tendency to give too much weight to recent experience, buying what has done well and selling what has done poorly. Another mistake I cover is the tendency to be influenced by the herd mentality.
This new study contributes to the literature on just how costly bad behaviors are to individual investors. Instead of trying to forecast which industry (or stocks) will be the best performers, investors should focus on designing an asset allocation plan and adhering to it, rebalancing along the way as required.
Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.
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