Why we trade | the morning star

There are certainly legitimate reasons for casual trading. Some trades are the result of long-term planning and the execution of a solid strategy.

However, repeated studies, including Morningstar’s annual survey Watch out for the gap report, demonstrate that actively trading investors tend to underperform the market. If the trading is harmful, why does the trading behavior persist?

As with most things involving human decisions, the answer is “it depends”. There are at least four distinct motivations for problematic trading. On the emotional side, we have the usual suspects: fear and greed. Cognitively, we can highlight overconfidence and sensation seeking. Here, I’ll give a brief overview of each, and we’ll dive deeper into the causes and solutions in the coming weeks.

To fear

“I know what we agreed, but I can’t afford to lose any more money,” is a familiar theme for financial advisors during bear markets.

In the summer of 2020, I had the opportunity to attend a call between executors and beneficiaries of a trust. Beneficiaries feared further losses and wanted to significantly reduce their equity exposure.

In the end, since the terms of the trust severely limited the percentage of money that could legally be moved, the family decided to stay the course. A year later, they were grateful they did.

Faced with the pain of a large loss, some investors are willing to deviate from their long-term strategy in order to reduce the uncertainty of the moment.

In the long term, this is generally a bad idea given that markets have historically rebounded and rewarded investors for staying the course. In the moment, the feeling of power to act and the certainty of reducing risk exposure may seem more valuable than an abstract possibility of future rebounds.

Greed

Desire is a powerful engine. When billionaires fill the airwaves with stories about turning their $2,000 retirement fund into $5 billion, it’s hard not to be excited about investing. However, these types of winnings are extremely rare, and the speculation that leads to them is more like buying lottery tickets than investing.

Greed can outsmart investors in a similar way to fear. Intense emotion clouds judgment and clouds strategic thinking. Greed leads some to invest far too much money in speculative investments, or to ride the bullseye, buying more and more in hopes of timing the peak, only to be left with the bag when the hype dies down. and let the herd move on.

too much confidence

Overconfidence is the degree to which an investor overestimates their ability to generate returns. Studies have linked overconfidence to memory biases, the belief that one has superior information or skills, learning the wrong lessons from past successes, confirmation bias, wishful thinking pious, gender and inability to deal with unknowns. [1], [2], [3], [4] All of these things can add up to the belief that we know better than the market.

The irony is that overconfidence leads to frequent trading and frequent trading leads to underperformance. [5] So the more you think you are “in the know” and the more confident you are that your knowledge and skills will help you beat the market, the more money you stand to lose to those who ignore all that special information and don’t do nothing.

The search for sensations

Finally, let’s talk about one of the best-known secrets of the investing world: playing the market is an adrenaline rush.

While we can talk about buy-and-hold as a superior method of generating returns over time, the reality is that many people aren’t interested in a long, slow road to eventual wealth. What interests many people in the stock market is the potential for quick money and the hunt for 10, 20 or 100 bags. [6]

Market players are more attracted to stocks that have lottery qualities like high idiosyncratic risk and high volatility. Penny stocks, junk bonds and “meme stonks” attract high-stakes speculators. The idea is the same as playing the lottery or going to the casino: with each transaction, you have a high probability of a small loss (your initial investment) and a small probability of an astronomical gain. Part of the appeal of this type of trading is the sheer entertainment value. [7]

There’s a lot to unpack when it comes to stock market betting, and we’ll certainly do that in future articles. For the moment, I have only two remarks to make. First, gambling and investing are different games, and they are played by different rules. I’ve said it before, but it bears repeating: speculation is legal and fun, but it’s not the same as long-term investing and shouldn’t be done with the savings of a lifetime.

Summary

In conclusion, despite an overabundance of evidence showing that trading is dangerous to our wealth, many of us still do it. The fearful trader wants to reduce the uncertainty and pain of loss. The greedy trader wants to increase his earnings. The overconfident trader believes he has superior knowledge or skill, and the player enjoys the thrill of trading.

Not all investors are motivated by the same things. If you know what motivates your own behavior, you’ll have a better chance of improving it by employing strategies to counter bias, manage emotions, and reduce the potential for significant harm.

References

[1] Barber, BM, & Odean, T. (2000). Trading is dangerous for your wealth: the performance of common stock investments of individual investors. The Journal of Finance, 55(2), 773–806.

[2] Gervais, S., & Odean, T. (2001). Learn to be overconfident. The Review of Financial Studies, 14(1), 1–27.

[3] Glaser, M., & Weber, M. (2007). Overconfidence and the volume of trade. Geneva Risk and Insurance Review, 32(1), 1–36. http://www.jstor.org/stable/41953463

[4] Walters, D. and Fernbach, P. (2021) Investors’ memory of past performance is positively biased and predicts overconfidence, PNAS, 118(36).

[5] Barber, BM, & Odean, T. (2000). Trading is dangerous for your wealth: the performance of common stock investments of individual investors. The Journal of Finance, 55(2), 773–806.

[6] This is a term coined by the folks at the Motley Fool to refer to a stock that pays 100 times your initial investment.

[7] Dorn, D., & Sengmueller, P. (2009). Trading as entertainment? Management Sciences, 55(4), 591–603.

Leave a Reply

%d bloggers like this: