Investor decisions

19th September 2012

Now recent research confirms this, up to a point.  Which is a weasel-worded way of trying to convey the idea that I wasn't exactly right but don't want to admit it.  Before we get all excited, however, the general idea still applies: experience helps, but only up to a point.  And the point is very, very sharp and very, very expensive.


Maximilian Koestner, Steffen Meyer, and Andreas Hackethal in Do Individual Investors Learn From Their Mistakes? have picked up on the recent evidence that suggests investment performance does improve with experience. This, of course, isn't the first time that a nice theory has been undermined by nasty data, but it's a fascinatingly nuanced study.  In essence, most of us get better, but only in certain ways.  In others we remain as behaviorally challenged and frantically busy as ever.

On the positive side greater investment experience correlated with less trading – we turnover our portfolios less often.  In the main overtrading is mostly associated with overconfidence (see: Overconfidence and Over Optimism) – we simply think we're better at predicting the future than we actually are.  This makes sense, because noting that we continually make mistakes in forecasting is the sort of the thing the averagely self-aware investor ought to notice, after enough losses.

This might also be an outcome of regret (see: Regret), where if we continually make investing errors of judgement the pain we experience will eventually cause us to trade less often.  Remember that sins of commission – selling stuff that goes on to do well – hurt less that sins of omission – failing to buy stuff that does equally well.  Reducing trading will tend to reduce the opportunities for experiencing regret: and there's nothing quite as effective as pain as a learning mechanism (see: Of Mice and Templeton Moments).

Aversion therapy

Now if we can tie the reduction in overconfidence to an increase in trading experiences through a relatively simple learning mechanism we might equally expect that other behavioral biases which don't lend themselves to similar cause and effect type relationships would be less impacted.  This, it appears, is also the case because more experienced investors are still affected by the disposition effect and are still woefully underdiversified, at least according to the standard theories of portfolio management.

The disposition effect is our tendency to sell our winners and run our losers which is probably a side-effect of loss aversion (see: Disposed to Lose Money).  We hate losses so much that we sell our winners to lock in our gains and we keep our losers in the hope of making back our losses.  In general this is the wrong thing to do – losers tend to keep on losing and winners tend to keep on winning.  Loss aversion is so powerful that it doesn't seem to be greatly impacted by experience, although reducing overtrading will tend to reduce the frequency of such behavior (see: Loss Aversion Affects Tiger Woods, Too).

Talkative traders

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Mindless With Money: How to be a mindful investor

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