By: Larry MacDonald
Academics have found that people tend to overrate their abilities. Survey a group of people and chances are, the majority will say they are better than average at some skill. For example, Svenson surveyed a group of car drivers and found a majority regarded themselves as more skillful than the average driver.
This same psychological tendency toward overconfidence is said to afflict active investors (at least before the bear market of 2008 came along). And like other groups, the tendency toward overconfidence leads to greater risk taking, which in the stock market manifests as over-trading and under-diversification.
Over-trading: Barber and Odean published a 2000 paper that examined the trading histories of 60,000 U.S. investors at discount brokerages between 1991 and 1996, segmenting them into five groups according to frequency of trading. They found each quintile earned nearly the same gross return, but when trading costs were factored in, net returns went down as trading activity went up.
Under-diversification: A 1995 research paper by Morgan looked at the portfolios of over 3,000 U.S. individuals. Of those invested in stocks, one-stock portfolios were most common. Only 5 per cent held more than 10 stocks.
(Thanks to Richard Deaves’ book ‘What Kind of an Investor are You” for pointing out these studies).
2 Responses to “ Investors and overconfidence ”
Investing is too easy. Open an account, put some money in and start trading. Most people I know see it that way. They do not understand that you need to do your homework and put a consistent effort into building solid portfolios. Then maybe you have a chance at “outperforming”.
CSC
canadiansmallcap.blogspot.com
By CanadianSmallCap on Feb 13, 2009
I have only three stocks in my portfolio. That’s because I have an insignificant fraction of my savings in my trading accounts, not because I’m not diversified.
By Patrick on Feb 14, 2009