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Which Investment Behaviors Really Matter for Individual Investors?

I came across this study the other day – Which Investment Behaviors Really Matter for Individual Investors? by a group at Goethe University in Frankfurt.

The aim of the study was to examine various investor behaviours and see if these behaviours had any impact if any upon investor returns. As the study points out there have been numerous studies that have looked at single variables such as overtrading, gambling like behaviours and a lack of diversification. And it is well established that many aberrant behaviours do have a substantial impact upon returns.

However, this study was somewhat more ambitious in that it looked at ten variables simultaneously. The variables they looked at were as follows.

  1. Portfolio turnover: Active trading volume (excluding savings plans) scaled by portfolio value as a proxy for trading activity and investor overconfidence.
  2. Trade clustering: Clustering of investors’ trades in time as a proxy for the absence of narrow framing (a narrow-framing investor makes investment decisions individually and not in a portfolio context).
  3. Disposition effect: Tendency to sell securities that have increased in value and keep those that have lost value.
  4. Leading turnover: Tendency to systematically trade before other investors (in the same security in the same direction)
  5. Forecasting skill: Ability to systematically realize excess returns on purchased securities.
  6. Trend chasing: Tendency to purchase funds that have recently increased in value.
  7. Home bias: Preference for investing in German stocks or funds with Germany as their investment theme, thus neglecting international diversification.
  8. Local bias: Preference for investing in local stocks (i.e., in companies with head-quarters close to the investor) or local funds (i.e., funds managed by companies geographically close to the investor).
  9. Lottery-stock preference: Investment in stocks with lottery-like characteristics (low price, high idiosyncratic volatility, and high idiosyncratic skewness).
  10. Under-diversification: Investment in only a few securities and/or highly correlated securities.

Interestingly, the study found that only two behaviours had a significant impact upon returns – lottery stocks and a lack of diversification .Removing the lack of diversification lifted performance by 4% and avoiding lottery bias lifted performance by 3.1%  Lack of diversification is easy to understand since the literature on this is pretty clear. Appropriately structured diversification that is both market and instrument based both increases returns lowers the volatility of returns that a portfolio can achieve. There is no argument here.

The concept of lottery stocks needs to be explored in more depth since this is not well explained by the paper. Within trading there is a perpetual confusion between volatility and trend – the two are not the same. Volatility is a measure of the speed and magnitude of price movement, it is not directly observable and it has no bias.

This lack of bias is very important for traders to understand since it is a  trap for the unwary. A key sign that someone does not understand what they are talking about is when they refer to upward volatility.

If I have a stock that is valued at $1.00 and a 30 day volatility of 20% that means that I can have a reasonable expectation that over the next 30 days the price trajectory of the stock will be found somewhere between $0.80 and $1.20. It does not mean that it will go up 20%. The natural assumption of traders is that if a stock has high volatility then it will go up by a large amount – this is an incorrect assumption.

Traders too often ignore the role of volatility within the decision making process and I think this is not only a function of a lottery bias but also a failure in understanding what an ideal move looks like. At some stage during the mentor program I always get the participants to find a stock that represents to them the ideal move. We then take this move and begin to look at the fundamental building blocks of the price action. Within this it is also necessary to look at the role of volatility – that is what is the current volatility of the stock in relation to its historical volatility.  From my perspective the ideal stock move has only a few basic characteristics. And these are easy to elucidate.

  1. Stock is breaking out from a base.
  2. Volume is increasing.
  3. Historical volatility for the instrument is below the average historical volatility.

Note that the trend requirement and volatility requirement are separate functions – this is because as I have said they are not the same. This is despite them being treated as one and the same by most.

I think that what the paper has identified is the tendency of traders to buy high volatility instruments that are not trending. Locally we would call these dogs, my guess is that they are generally tips that either came from their brokers or alternatively their idiot brother in laws.

Intriguingly, the paper suggests that trend following is a negative behaviour or bias. I attribute this to academics simply not understanding how any form of trend based trading works and thereby falling prey to their own bias.

Footnote. Coincidentally at the same time I came across this article this article  which dropped into a junk mail address I keep for such things.

This article contains some interesting statements.

            A big myth is that investing offshore leads to better returns or better diversification. Both are untrue. There are more than enough great shares in Australia to profit from.

I am always intrigued when I see people offer such advice since it is clearly not what the evidence shows. In terms of capitalization the Australian market offers less than 2% of world equity values. We are a tiny closed system. Evidence of this is that since the GFC the US market has gone up 173%. The local market has gained about 20%.

Select eight to 12 stocks from the top 20 shares on the Australian market paying good dividends. Divide your money between them and leave the stocks in the bottom drawer, as history has proven they will grow over time. Also, remember smaller portfolios are easier to manage and represent lower risk. The more stocks you have, the more work is needed to manage your risk and the higher your transaction costs.

Interestingly, this contradicts advice given earlier in the article about learning to sell. The notion of smaller portfolios reducing risk is also wrong. The natural extension of this is that a portfolio will one stock in it should have no risk at all.

However, the biggest problem with this is that it simply ignores the notion of correlation within a closed index. Buying 8 to 12 shares within the ASX 20 is tantamount to buying the index itself. So you actually have one position. Again diversification is ignored which is fine if you are an index trader but if you are a stock trader diversification cannot be ignored.

To give you a sense of the correlations between the top 20 I have generated the following correlation matrix.

Screen Shot 2014-02-28 at 10.16.55 am

 

I have coloured those with a correlation greater than 0.50 in purple and those with a negative correlation in orange.

 

 

The End Of The World Is Coming

During my sabbatical I got bounced the video below – it only goes for about 90 seconds so its easy to get through. If you are under the age of 25 cannot concentrate for more than 90 seconds the general gist of the story is that the current market looks exactly like 1929 and the world is going to end next week or some such thing.


 

I am always intrigued when I look at images that overlay one segment of market history with another. To the untrained eye they look very compelling – it is the old argument, if they look the same then they have to be the same. however, such charts are really quite naive and display a lack of understanding of the importance of context. Interestingly I am not the only one this sort of comparison has annoyed. I found the following chart on the WSJ

Screen Shot 2014-02-28 at 8.25.10 am

It quite correctly looks at the two markets in terms of the returns the market had been generating up until today. The accompanying article is well worth reading.

The Woes of Wall Street: Why Young Bankers Are So Miserable?

Who gives a shit is the only response I could think of to the implied question. If you are naive enough to believe that working in the finance industry is the same as doing charitable work in Africa then you are profoundly deluded.

Jaguar F-type R Coupé

 
 

Take One Step Forward And Two Steps Back.

Once again Michael Pascoe gets it right. I worked in broking for years and two things amazed me. Firstly, how little brokers know about markets. They have a lot of platitudes in their sales arsenal but very few have a deep understanding of how the market actually works. Secondly, it is the most self interested business in town, very rarely were the interests of the clients at the forefront of any decision that was made.

10 Trading Tips to Fuel Your Profits

Caroline Stephen - Financial Journalist and host of www.talkingtrading.com.au

Caroline Stephen – Financial Journalist and host of www.talkingtrading.com.au

Hi, I’m Caroline Stephen. I’m the host of the Talking Trading radio show at www.talkingtrading.com.au. Each week I bring you free interviews so that you can hear what the movers and shakers are doing and trading in today’s markets. If you haven’t registered on that website yet, what in the heck are you waiting for? You’ll love it!

We’re nearly ready to launch, so you’ll get the first set of episodes as soon as they’re ready.

My passion is financial journalism. I adore interviewing experts in the industry so that you can benefit from their wisdom about how to make money in the markets.

I’m in the process of writing a Special Report called ’50 Trading Tips to Fuel Your Profits’. Once it’s available I’ll give you a copy for free which I’m sure you’ll love. To get a copy, make sure you’re registered on www.talkingtrading.com.au.

Here’s a sneak peak to show you the first 10 tips.

1)   Associate with greatness. If you hang out with top traders, some of their magic will rub off.

2)   Write a trading plan that spells out clear entry, exit and position sizing rules. Without this, you’re a ‘shoot from the hip’ trader, destined to self-destruct.

3)   Grab yourself a Mentor who can guide you and stop you from making the mistakes that will distract and frustrate you.

4)   Be kind to yourself while you’re learning and realise that ‘school’s never out’ if you want to be a professional trader.

5)   Be patient. Trading is more ‘tortoise’ than ‘hare’.

6)   Just because you’re not making money this week is no slur on your character. Your trading results are not who you are.

7)   Your past is only your future if you allow it to be.

8)   Everything you want is outside your comfort zone. If you could get the results you wanted now, there would be no need to change.

9)   The markets act as a mirror. Sometimes you won’t like the reflection you see.

10)  This too shall pass. Remember this when you’re making losses… but also when you’re making huge profits.

Trade your plan. Trade well.

Caroline Stephen

About Caroline Stephen

Caroline Stephen is your trusted, unbiased voice on what it takes to achieve success in the markets. With a strong professional background in journalism with the ABC, her investigative skills have been highly coveted by a variety of different organisations, including the 7.30 Report TV show. She is now the host of the Talking Trading radio show.

Caroline is one of the founding partners of www.talkingtrading.com.au and her role as CEO enables her to develop dynamic trading friendships with market experts so that she can empower the traders who turn to her for advice and counsel.

 

Oh My Goodness… You’ve Given Permission to What?

goatNo financial condition is permanent unless you give it permission. Just what have you given permission to in your life that has taken hold? Might be time to re-assess…

I’ve been through a few wipe-outs in my life. I was wiped out emotionally when I didn’t get into the University course I craved. I had a business in Personnel while I was at University, which I drove into the ground. Then I was wiped out emotionally and financially when I invested in the now defunct Pyramid Building Society. Oh yeah… then, my extra wipe out happened when I lost the use of my arms for a couple of years and had to leave my corporate role to become a full-time trader.

Even with these wipe-outs… I firmly believed that no financial position I found myself in could become permanent, unless I let it become so. If I fed it with a negative attitude as it’s fertilizer, if I allowed it to take root within my mind set and flourish – then the state I was in at that time would be permanent. If I had let those downfalls hit me and plant themselves solidly, I never would have been able to mount another comeback, re-create myself, and move on.

There are no absolute certainties in life. Even as I write this, I hope I’ll never have to launch another ‘Louise Bedford recreation’ campaign. I can tell you, rebounding is no fun. However, I do hold onto the thought that each recreation has come a little more easily, thanks to the benefit of experience.

What are you hanging onto? Is there a life circumstance that you’ve allowed to take root like a noxious weed? Or are you prepared to be fluid in your views and create a totally different reality for yourself?

I can tell you that the best traders have planned on success long before their realities showed any signs of it at all. In their mind’s eye they can see the life they want to lead, the money they want to earn, and the people they want to associate with. They don’t like set-backs (who does?). However, they compartmentalise their current reality long enough to work on the reality of their future. They box up their circumstances and refuse to let the past dictate what will happen in their lives over the next few years.

Right now, you may be neck deep in problems. You may be stabbed with feelings that you’re not worthy of success. You may be picturing a future that doesn’t involve you spreading your wings.

I guarantee that if you feed these circumstances, and give them permission to take root, then you are giving them permission to become a permanent fixture in your life.

No financial situation is permanent, unless you give it permission.

One Habit You Must Cultivate

It’s said that in five years we actually experienced a lifetime change that our grandparents experienced over 75 years. Do you know what? Things are galloping forward faster and faster. It’s not just technology. It’s how we he handle it. We have constant interruptions. We have phones that beep in the middle of the night – and we answer them! It means we’re sleep deprived. We actually have trouble concentrating unless we have our phone with us.

If you’ve ever left the house and realized that you don’t have your phone with you and panicked, you’ll know what I’m talking about. My goodness, doesn’t it sound a bit like an addiction?

Things have also changed on the career front. No longer do we have a job that lasts us a lifetime. We are said to have between three and seven jobs – not just jobs – absolute changes of career. Complete retraining required.

Do you know what they say is happening? It’s during those times of retraining people are falling into poverty. They might be high-earning executives. They may have incredible positions of power. But when they’re unemployed, they go down to nothing – absolutely nothing. Sure, income protection can help you a bit, but you and I know that really living on 60-70% of what you’re earning before, you are going down into poverty in your mind.

Do you know what trading can do? It can act as your buffer. You no longer have to fear what the economy is doing. We can teach you how to trade regardless of whether the markets are going up, down, or sideways.

Another big major change that the futurists are telling is occurring is that people are starting to lack confidence. Not only are we lacking confidence, we’re actually portraying that emotion and developing children who are lacking confidence in their ability to earn. It’s a travesty and we need to call a stop to it now. Join with me. Make a stand. Tell yourself that you can do this, because I know that you can.

I have a challenge for you. This is one habit that you must cultivate if you’re seriously going to make an impact in any area of your life. I challenge you to avoid a trap of giving an 8, 9 or 10 in effort to an opportunity that really only scores a 3 or 4 (in size, importance, and the ability to create money or emotional satisfaction). What are you applying too much effort to and what do you need to apply more effort to?

Might be a good time to do some reassessment here. Seems like a good time of year to do so.

Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets.

General Advice Warning

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