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Sunday, July 31, 2005

Human Behaviour – The Greatest Barrier To Trading Success

Australasian Investment Review writes about human psychology, rationality and how it affects investing and trading. They point out that overtrading is one common mistake of overconfidence which drags down annual returns. The Big Picture has added some comments to this article. You can also read 2 posts in my blog about overtrading (see the links below).

Human Behaviour – The Greatest Barrier To Trading Success
Australasian Investment Review
May 30 2005
Have you ever held on to a stock too long, in the vain hope it would return to the price at which you bought it, even though you knew in your heart of hearts this was unlikely to happen? Well, you’re not alone.

Tilson suggests that one of the biggest problems facing human investors is that they tend to be overconfident in their view of things. Not just "robustly", but "wildly" overconfident. He provides the following statistical examples:

- 82% of people say they are in the top 30% of safe drivers;
- 86% of Harvard Business School students say they are better-looking than their classmates;
- 68% of lawyers in civil cases believe their side will prevail;
- 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed;
- Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement, and how much the average person in the room would have. The average figures were $5 million and $2.6 million respectively.

Tilson explains overconfidence by suggesting that people generally remember failures very differently from successes. Successes were due to one’s own wisdom and ability, while failures were due to forces beyond one’s control. Thus people will tend to believe that with a little better luck or fine-tuning, the outcome will be much better next time.

Overtrading is a fine example of overconfidence, Tilson suggests. In a study of 78,000 individual investors at a large US discount broking house during 1991-96, average annual turnover was around 80%. The least active quintile, with an average annual turnover of 1%, scored a 17.5% annual return. The S&P return was 16.9% over the same period.

The most active 20% of investors, with annual turnover of greater than 100%, scored a 10% annual return.
Read further:
Australasian Investment Review: Human Behaviour – The Greatest Barrier To Trading Success

See also:
The Big Picture: Human Behaviour as a Barrier To Trading Success
Saving Money by Doing Nothing
Avoid Overtrading By Pausing After Losses