Investing is a difficult business.
Making decisions about which stocks to sell and which to buy is fraught with difficulties, simply because you cannot know for sure which will do better.
Amateur investors are much (much) worse than professional investors, such as fund managers, when it comes to stock selection.
Some research described in the book Thinking, Fast And Slow by Daniel Kahneman demonstrates the extent to which the average amateur investor is worse than a chimp.
Terry Odean from UC Berkeley studied the trading records of 10,000 brokerage accounts held by amateur investors over a seven year period, examining nearly 163,000 individual stock trades.
By looking at each example of an investor selling a holding in one stock and soon after buying another, he was able to identify occasions where investors believed one stock would do better than another.
Clearly the stock being sold was expected to perform worse than the stock being purchased shortly afterward.
This study found that, on average, the stocks sold by these amateur investors did better than the stocks they subsequently bought. In fact, they did a lot better!
On average, the ‘bad’ stocks outperformed the ‘good’ stocks by 3.2% a year.
Factor in the cost of trading and time spent out of the market, and these investors were actively eroding their wealth by making bad investment decisions.
Even random decisions, made by a moderately trained chimp for example, would be expected to do better than the investment trades analysed in this study.
Kahneman concludes “It is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to mind.”
In most cases, individual investors should not be picking individual stocks.
Buying funds, where professional investment managers are responsible for stock selection and monitoring, is a different business. Buying and selling stocks is always something best left to the professionals.
Photo credit: Flickr/Meneer Zjeroen
