Brad M. Barber and Terrance Odean in “Online Investors: Do the Slow Die First” write:
[Our work] examines changes in the stock trading behavior and investment performance of 1,607 investors who switch from phone based to online trading during the period 1992 to 1995. We document that young men who are active traders with high incomes and a preference for investing in small growth stocks with high market risk are more likely to switch to online trading. We also find that those who switch to online trading experience unusually strong performance prior to going online, beating the market by more than two percent annually. After going online, they trade more actively, more speculatively, and less profitably than before — lagging the market by more than three percent annually. A rational response to reductions in market frictions (lower trading costs, improved execution speed, and greater ease of access) does not explain these findings. The increase in trading and reduction in performance of online investors can be explained by overconfidence augmented by self-attribution bias, the illusion of knowledge, and the illusion of control. Online trading is like the old west,” warns Fidelity Investments. “The slow die first.” “Trading at home? Slow can kill you,” echoes a provider of internet connections. “If your broker’s so great, how come he still has to work?” asks E*TRADE. Another E*TRADE ad notes online investing is: “A cinch. A snap. A piece of cake.” “I’m managing my portfolio better than my broker ever did,” claims a middle-aged woman (Datek Online). In Ameritrade’s “Momma’s Gotta Trade,” two suburban moms return from jogging. Straight to her computer, a few clicks and a sale later, one declares “I think I just made about $1,700!” Her kids cheer, while her friend laments, “I have mutual funds.” And then there is Discover Brokerage’s online trading tow-truck driver. He picks up a snobbish executive who spots a postcard on the dashboard and asks “Vacation?” “That’s my home,” says the driver. “Looks more like an island,” says the executive. “Technically, it’s a country,” replies the driver. These advertisements entice and amuse. They assure the uninitiated that they have what it takes to trade online; tell them what to expect—sudden wealth; and what will be expected of them—frequent trades. They also reinforce cognitive biases, which, for the most part, do not improve investors’ welfare.
Active trading for the sake of actively trading is useless. Only trade when you have a plan. The writers above hit the mark.
The Psychology of Money
Steven Pearlstein of The Washington Post writes:
Chances are you know someone who sells his stocks only if they have gone up, never if they have gone down. Or the person who regularly runs up credit card debt but would never think of dipping into her savings account. Or maybe the guy who refuses to pay $15 to have someone else mow his lawn but wouldn’t dream of mowing anyone else’s lawn for $15. And what about those folks who flock to all-you-can-eat buffets and cell-phone plans with unlimited minutes?
TurtleTrader® comment: 4 quick reasons why Trend Following works. More.
According to traditional economic theory, such people shouldn’t exist. People aren’t supposed to careen through life systematically making bad bets, leaving money on the table, assigning different values to the same products and paying too much for things they don’t really want. Homo economicus is supposed to make intelligent, rational choices that maximize his or her wealth and financial well-being.Reality, of course, turns out to be quite different from theory. As economic actors, people are as likely to be governed by their emotions as by reason, by prejudices as by careful cost-benefit analysis. Their rationality is bounded by limits on their time, intelligence and the information at their disposal. Or that investor who won’t sell a falling stock, because that would mean admitting a loss.
TurtleTrader® comment: The failure to admit a loss allows others to win big.
He would be better off deciding which stocks to hold on to based solely on his expectation of their future performance, regardless of what happened in the past. Another well-documented tendency in people’s economic behavior is that they assign higher value to things they already have. Ziv Carmon, a French marketing professor, and MIT’s Ariely divided a group of nearly 100 Duke University students into two groups. One group was asked to state the highest price they would pay for a ticket to the NCAA Final Four basketball tournament, a highly prized item on that campus.The other group was told to imagine they had such a ticket and was asked for the lowest price at which they would be willing to sell it. The median selling price was $1,500; the median buying price was $150. This tenfold difference, according to Carmon and Ariely, results from the different ways in which buyers and sellers think about a transaction.
Buyers tend to think about what else they could do with the same amount of money, while sellers focus on the pleasure or enjoyment they would forgo. In a recent study, Thaler, Loewenstein and two other researchers found that New York taxi drivers could earn 20 percent more each year if they would put in longer days when demand was high (rainy days, for example) and shorter ones when demand was low. Instead, drivers preferred to work each day until they covered their costs and paid themselves a target wage — then quit for the day regardless of the market condition. One of the key assumptions of economic theory is that money is money. But behavioral economists have shown that people routinely violate that principle by segregating income or costs into different mental buckets or accounts, even when it winds up hurting them financially. Many people, for example, have vacation homes and time-share condominiums that wind up costing them more for each day of use than if they had vacationed at a nearby hotel. But more often than not, such comparative calculations are never made because vacations are supposed to be paid for out of current income while the condo is mentally accounted for under a separate investment category.
Other studies show that while people are apt to go right out and spend all of an unexpected windfall such as a bequest from a distant aunt, they are loath to spend profits they make on investments. In fact, experience shows that people get very confused when thinking about sunk costs — the money they have already spent for a project or purchase or investment. Rationally, they should forget about sunk costs and focus only on what the costs and benefits are going forward. Emotionally, they can’t. Psychologists Amos Tversky and Daniel Kahneman of Princeton University explored a situation in an oft-cited experiment involving a theater ticket back in 1984. They told one group of subjects to imagine that they have arrived at the theater only to discover that they have lost their ticket. Would you pay another $10 to buy another ticket? they asked. A second group were asked to imagine that they are going to the play but haven’t bought a ticket in advance. Then, when they arrive at the theater, they realize they have lost a $10 bill. Would they still buy a ticket? In both cases, the subjects were presented with essentially the same simple question: Would you want to spend $10 to see the play? That’s largely the way the cash-losing group thought of it, with 88 percent opting to buy the ticket. But the ticket losers, focusing on sunk costs, tended to frame the question in a different way: Am I willing to spend $20 to see a $10 play? Only 46 percent said yes.
This focus on sunk costs and the aversion to losses play out every day in financial markets. Numerous studies have shown that investors systematically make bad decisions because of their reluctance to sell stocks or bonds on which they have a loss.
TurtleTrader® comment: Can there be a greater example than Enron?
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