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Friday, August 19, 2016

Six types of gamblers on the stock market

By Fong Wai Mun

The lure of making a quick buck is all too common among individual investors. In my book, The Lottery Mindset: Investors. Gambling and the Stock Market, I began with the statement that "investors have a remarkable ability to lose money in myriad ways''.

I then went on to show how different types Of investors "donate" their hard-earned money to the stock market through various ill-conceived investment strategies. They are:

■ The overconfident: They overrate their ability to read the market, choosing to own just a handful of stocks. Instead of spreading their investments across many stocks in different sectors to diversify risks. They also display a "home bias" by putting the bulk of their investment in domestic stocks instead of diversifying into a more international portfolio. Investors who under-diversify are in effect betting that their stock picks will be winning bets. Unfortunately, most investors are poor stock pickers. Research shows that investors who hold less diversified portfolios do worse on average than those who hold diversified portfolios.

■ Market timers: They try to "beat the market" through market timing. piling into the stock market before a good runup and cash out before a rundown. When market timers try to predict the future by extrapolating from past price trends, they become "trend chasers". Research shows that on average, trend chasers lose money compared to buy-and-hold investors. The empirical evidence is that money tends to flow into the market after superior past returns, and (importantly), before inferior subsequent returns.

■ Pattern chasers: Stock prices fluctuate randomly, giving rise to the description "random walk" used by statisticians. Random sequences (like the outcomes from consecutive coin tosses) can sometimes show up as intriguing patterns such as six heads out of eight throws). What's interesting is that while most people acknowledge the unpredictable nature of coin tosses, they have a much harder time applying the same logic when they are investing their hard-earned money, The result is that investors read too much into noisy stock price fluctuations and trade to their detriment.

■ Active contrarians: Unlike trend Chasers, contrarians tend to sell when the market is "hot" (have risen strongly recently) and buy when the market is "cold''. But if stock prices are random walks, both trend chasing and contrarian trading are futile. As legendary investor Warren Buffet once said, the stock market is "a game of a million inferences". in other words, it is foolhardy to try to outguess the market since stock prices are influenced by so many factors, rational and irrational.

■ The overtraders: They buy and sell actively instead of adopting a passive buy-and-hold strategy focused on long -term returns. In the 1960s, American investors held stocks for an average of about eight years; now it is less than two years. A similar trend has also been observed in many Asian markets. Investors eagerness to trade actively is not surprising as technology has made it easy and cheap to trade online and around the clock. Yet. while trading might he an entertaining distraction, research shows that investors who trade frequently underperform those who are less active.

■ The lottery player: Many investors are strongly attracted to stocks with low prices such as penny stocks, stocks with highly volatile returns, and stocks with prices that have risen strongly in recent months. Researchers use the term "lottery-type stocks" to describe stocks with such characteristics. As the name suggests. lottery-type stocks attract investors with a strong desire to gamble. Just as real lotteries give people the hope of becoming instant millionaires, so highly volatile or speculative stocks are highly sought after for a "shot at riches", while "'boring" stocks are sidelined. The demand imbalance ultimately leads to lottery-type stocks being overpriced and yielding poor returns compared to more stable stocks. Indeed. research evidence shows that on average, the most volatile stocks underperform the least volatile ones by a very wide margin. Similarly, investors should be wary of stocks that attract intense media interest as these 'attention-grabbing-stocks are also likely to be punters' favorites.

Despite the myriad of behavioral biases, investors are not doomed. Poor investment habits can he reversed by acquiring investment literacy and putting this into daily practice. lnvestors can acquire investment literacy by reading investment books that discuss principles of investing. They should also learn to be aware of emotions and cognitive biases that can lead them into a minefield of bad investment decisions. Once investors know the right approach to investing, they should put this into practice and not waver. As the saying: "Sow a habit, reap a destiny."

The writer is associate Professor of finance at NUS Business School and advisory board member (Asia-Pacific) of Brandes Institute

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