How Do Individual Investors Manage to Lose Money in the Stock Market?

The Efficient Market Hypothesis claims that stock prices reflect all available information. According to the proponents of the Efficient Market Hypothesis, investors can’t beat the market indexes by stock picking. They say investors trying to find a secret formula are wasting their time because stock prices follow a random walk. Interestingly, this theory also implies that a monkey (not Insider Monkey; our monkey is the smartest monkey on Wall Street and doesn’t waste time throwing darts) selecting stocks by throwing darts at a newspaper’s financial pages can perform as well as a portfolio manager named Josef Lakonishok who picks stocks by using quantitative methods. Their claim: you can’t beat the market, but the market can’t beat you either (before expenses, of course).

Unfortunately, individual investors actually do worse than dart throwing monkeys: they manage to underperform the market even before accounting for expenses. How do individual investors manage to lose money in the stock market?

A study by Barber and Odeon (Journal of Finance, 2000) shows that an average household with an account at a large discount brokerage firm underperforms by an average 15 basis points per month based on Fama-French’s three factor model. This is based on gross returns (before expenses). Another interesting finding of this study was that an average individual investor would have been better off by not trading. Barber and Odeon compared the returns of stocks an individual investor sold to those they bought. The stocks these investors sold performed better than the stocks they bought.

An obvious conclusion of the study is that individual investors who traded more frequently earned less than the average household. The returns of the frequent traders averaged 11.4% while the average household earned 16.4%. The market return during the same time period was 17.9%. Most of the underperformance of frequent traders can be attributed to high transaction costs. They not only managed to lose money on their trades (before expenses) but also waste a big chunk of money on commissions and other fees.

Barber, Lee, Liu and Odeon also analyzed all trades on the Taiwan Stock Exchange between 1995 and 1999. The results provide strong evidence for the underperformance of individual investors. The aggregate portfolio of individual investors suffered an annual underperformance of 3.8 percentage points. Meanwhile, the Taiwan Stock exchange had an annual turnover of nearly 300%. The authors wanted to know why individual investors had such an appetite for trading and then got poor results. Their only answer: overconfidence. This theory was supported when they made another discovery: In 2001, the number of day traders greatly reduced right when Taiwan introduced a legal lottery system. Before, lotteries were illegal. Subsequently, the turnover in the stock market went down by 25%. Similar to what happens in the US, the stocks individual investors sold outperformed the stocks they bought by 76 basis points per month (using Carhart’s four factor model) during a holding period of 140 trading days.

Frazzini and Lamont analyzed individual investors’ market and style timing skills using mutual fund flows. They found that on average, retail investors direct their money to funds that will have low returns. They allocate funds from future winners to future losers. They’re also overweight growth stocks in general.

Interestingly, individual investors perform relatively well during the first 3 months, but subsequent returns more than neutralize short term gains and individual investors lose on the average. Authors contemplate that either huge flows into these funds push the stock prices temporarily higher or individual investors benefit from the momentum effect in the short run.

All these studies show individual investors are very successful at finding ways to lose money. Efficient Market Hypothesis propagators ask you to believe that individual investors lose money because they are just unlucky.

The truth is that markets are inefficient and there are investment strategies that will underperform (or beat) the stock market in the long run.

This is a guest post by Insider Monkey.

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