Want to increase returns by 8.5%? Close your online trading account.

January 18, 2013

A new paper gives strong indication that on average, individual investors are really poor investors. I mean, really bad. Enough that by the end of the day, they’d be better off sitting in cash than trading on their own.

This dude gets it. By Photoholgic

It treats them to the sort of analysis which we usually subject mutual fund managers to, and finds that they’re no better, i.e. worst than a passive strategy. Meyer, Schmoltzi, Stammschulte, Kaelser, Loos and Hackenthal write in “Just Unlucky? A Bootstrapping simulation to measure Skill in Individual Investors’ Investment Performance” :

This paper disentangles skill and luck in individual investors’ investment performance using a four-factor model and apply bootstrapping simulations pioneered in the mutual fund literature to distinguish skill from luck. We use a comprehensive dataset of 8,621 individual investor portfolios from a German online broker, spanning a timeframe from September 2005 to April 2010.

We find that 89% of individual investors exhibit negative skill (α ≤ 0) when measured on a gross basis and 91% when considering returns net of costs and expenses. An individual investor with an average level of risk-taking depicts an investment performance of approximately -7.5% per year for gross returns and of -8.5% per year for net returns. (emphasis mine)

Note that individual investor gross returns were negative. This indicates that the vast majority of individual investors are, for the most part, significantly under-performing a passive strategy, before fees. They are making bad decisions, even before we factor in the cost of executing those decisions. This contrasts to prior findings that gross returns are about the same as the market, and transaction fees reduce the returns. It’s filled with interesting tidbits, like that the financial crisis in 2008 reduced measured skill, i.e. :

The sample period contains the financial crisis of 2008 and 2009. We find that skill levels of individual investors are less negative in our sample period prior to the crisis, i.e. from September 2005 to the end of 2007.

And the conclusion is fairly strong:

The results are a clear case for passive strategies. Hence, banks, politicians and individual investors might want to reconsider investment strategies and policies to help investors improving the investment skill. In the light of these findings and Campbell’s (2006) call for financial economists to come up with solutions to the investment mistakes of individual investors becomes even more urgent.

The paper has a great review of the literature, including this tidbit on mutual funds:

Generally, there has been some consensus in the fund literature that active investing cannot beat a passive benchmark and that funds rather exhibit underperformance when trying to do so. Hence, the general conclusion is that buy-and-hold appears as the dominant strategy… a fund with a positive expected α before costs attracts inflows until its assets under management reach the point where expected α, net of costs, is zero while outflows drive out funds with negative expected α vice versa.