Overconfident investors are more likely to sell after a market crash, locking in losses and missing out on market recoveries, says a paper published in the Journal of Behavioral Finance this year.
Selling after a market crash can be one of the biggest mistakes an investor can make. Since 1942, the average bear market for the S&P 500 has lasted little more than 11 months, with an average loss of 37.1 per cent, while the average bull market has lasted more than four years, with an average return of 147.2 per cent, according to First Trust Portfolios L.P.
The implicit assumption is that sellers will time their re-entry into the market accurately.
That is a poor assumption, says a separate study by Dimensional Fund Advisors. It looked at 720 different stock timing strategies and found that only 30 outperformed a buy-and-hold approach.
But before you start digging for the details on those 30 winning strategies, know that they are unlikely to continue working in the future – and the reason they outperformed in the first place was mostly just luck.
As the authors of that study note, “if you ask a large enough number of people to repeatedly flip a coin, someone will flip 10 heads in a row. Similarly, we should expect some strategies to generate outstanding results just by chance if we try enough parameter combinations.”
In the first study, the researchers were able to identify overconfident investors by cross-referencing respondents from two surveys of U.S. investors in 2018 and creating two comparison variables: “perceived investment knowledge” and “actual investment knowledge.”
People were asked to rate their level of investment knowledge, and this formed their perceived investment knowledge score. The surveys also contained 16 questions that could be used to score their actual investment knowledge.
If an investor’s perceived investment knowledge was high but their actual investment knowledge was low, they were categorized as “overconfident” – they didn’t know as much as they thought they did. Conversely, investors with low perceived investment knowledge but high actual investment knowledge were categorized as “underconfident” – they actually knew a lot but didn’t think they did.
Those who rated their knowledge as low and also had low actual knowledge were labelled “accurately unaware” – they knew they didn’t know much. And finally, those who rated their knowledge as high and had high actual knowledge were “accurately aware.”
In response to a 20-per-cent market crash, overconfident investors were more likely than the other groups to sell out of the market. Accurately aware investors were another story: They were more likely to buy.
Overconfident investors were also the most likely to buy cryptocurrencies, use margin accounts, utilize options and trade penny stocks. These more aggressive trading activities tend to be associated with DIY investors.
While not everyone who opens up a discount brokerage account will engage in these activities, the access to these types of products and strategies is arguably too tempting for some. Sign away enough responsibility and you are free to blow yourself up. Caveat emptor.
Discount brokerages are known as order execution only (OEO) platforms and have restrictions on the kind of advice they can give DIY investors. These investors may not want to work with traditional advice channels and instead are turning to social media and other unlicensed sources of information, for better or worse, in tandem with their DIY accounts.
The findings suggest that overconfident investors might therefore benefit from additional guardrails. This supports the Ontario Securities Commission’s proposed Statement of Priorities for 2024-2025 (item six), which suggests the regulator is open to the idea of non-tailored advice on DIY platforms.
In the meantime, the take-away of the study dovetails with timeless advice: Investor, know thyself. Perception, it turns out, is not reality when it comes to investment knowledge.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.