Edgy Investors

Although most investors have no edge on the market there’s a proportion of them that persist in trading actively, the main effect of which is to enrich their brokers. There are various explanations of why this occurs, but it seems to come down to some combination of inherent overconfidence and a perverse refusal to take account of negative information. 

This is particularly dangerous in calm periods such as those we’ve been experiencing in markets over the past few years.  In such times momentum strategies are particularly effective – and serve to supercharge the behavior of naturally overconfident individuals. The end results are usually not pretty..

Snow Business

We’ve covered the basic research into overconfidence here a number of times. Odean and Barber (see O is for Overconfidence) showed that the more investors trade, the more they tend to lose – high turnover investors spend more on fees and end up losing money relative to less active traders. In fact only the least active accountholders were able to generate a return in excess of an S&P500 index tracker.

In 2009 Mark Grinblatt and Matti Keloharju studied a bunch of Finnish traders in Sensation Seeking, Overconfidence and Trading Activity. In Finland all males have to take an Army psychometric test at age 20 – quite what the Finnish military is worried about isn’t clear, other than a tendency for adult male Finns to drink a lot, play chess and roll about naked in the snow, often all at the same time. The researchers then matched the results of these tests and driving violations to frequency of trading and – no surprise – found that overconfident, sensation seeking individuals were the most frequent traders.

Wrong But Right

As ever, the behavior of investors is conditioned by the times that they find themselves in. People tend to extrapolate the recent past into the indefinite future, which is fine when you’re dealing in the movements of tectonic plates, but less smart if you’re trading on the edge of an active volcano.  Given this it’s no surprise that momentum strategies – essentially buying shares that have gone up in price – tend to work extremely well in low-volatility markets and can fail dramatically when volatility increases and markets go in reverse.