Retail Investing Psychology - Are you one of them?

#1 Asymmetric Information

The concept of Asymmetric Information centers around a situation in which there is unequal knowledge between each party to a transaction, that one party has better information than the other party. This type of asymmetry creates an imbalance in a transaction.

Investors who do have unusual non-speculative needs to trade could dramatically lower their asymmetric information and transaction costs by investing in low cost, no load mutual funds. Why do so many investors self-manage portfolios when they could earn better returns with lower risk in low-cost mutual funds, such as index funds? And why do investors with portfolios of individual equities trade actively when doing so lowers their expected returns? We turn to possible behavioural explanations.

Overconfidence

Overconfidence can explain the relatively high turnover rates and poor performance of individual investors. One variety of overconfidence is a belief that one knows more than one actually does, which is sometimes labeled “miscalibration” or “overprecision.” Dorn and Huberman (2005) document that investors who think themselves more knowledgeable than average churn their portfolios more. They argue that “people are more willing to bet on their own judgments when they feel skillful or knowledgeable.”

Sensation Seeking

A noncompeting explanation for the excessive trading of individual investors is the simple observation that trading is entertainment and appeals to people who enjoy sensation-seeking activities such as gambling.

Familiarity

There is debate about whether individual investors possess an informational advantage about companies that are close to where they live or in their industry of employment. Some scholars argue that individual investors are better informed about the prospects of companies close to where they live or in their industry of employment and that this information advantage leads to superior investment performance. Others argue individuals over-invest in these stocks because they are familiar to them, leading to under-diversification and average or even below-par returns.

#2 The Disposition Effect: Selling Winners and Holding Losers

Individual investors have a strong preference for selling stocks that have increased in value since bought (winners) relative to stocks that have decreased in value since bought (losers). This behavior otherwise known as the “disposition effect”—investors are disposed to sell winners and hold losers.

Why do investors prefer to sell winners?

This disposition effect can be attributed to a combination of prospect theory, regret aversion, mental accounting, and self-control issues.

#3 Reinforcement Learning

The simplest form of learning may be to repeat behaviors that previously coincided with pleasure and avoid those that coincided with pain. Several studies suggest that individual investors engage in such simple reinforcement learning. There needs to be deep reflection on the losses to actually promote growth in fundamental analysis.

#4 Attention: Chasing the Action

Individuals have a limited amount of attention that they can devote to investing. Attention can affect the trading behavior of investors in two distinct ways. On one hand, directing too little attention to important information (such as 10-k, economic data) can result in a delayed reaction to important information. On the other hand for the downside, devoting too much attention to social investing platforms like reddit with lack of self evaluation of the equity.

#5 Failure to Diversify

Risk averse investors should hold a diversified portfolio to minimize the impact of risk on their investment outcomes.

#6 Are Individual Investors Contrarians?

Are individual investors contrarians? Be fearful when others are greedy, and greedy when others are fearful. The phrase by famed investor Warren Buffett may be in the heads of investors, but how many is actually mindful of this and acts accordingly?