The more you know a stock the worse your performance gets
This blog from Klement renders yeoman service for HNWs by refuting the notion that HNWs should put all their eggs in one basket and then watch that basket really closely. The blog uses a clever study conducted by an Indian academic to attack the latter part of the proposition given in the previous sentence: “Didn’t Andrew Carnegie say the way to become rich is to put all your eggs in one basket and then watch that basket? However, the evidence is mounting that your performance becomes worse, the more you watch that basket.
Ellapulli Vasudevan looked at the portfolios of 308,000 Finnish investors between 1995 and 2014 as well as 76,000 US investors between 1991 and 1996. He found that many investors tended to buy and sell the same stock over and over again. About 40% of investors sold all of their holdings in a stock just to buy it again at a later time. And 10% of investors engaged in at least 6 of such roundtrips….As I have written before, these investors are more likely to sell their stocks when they are sitting on a gain than when they are sitting on a loss, but what is novel about Vasudevan’s research is that he shows what happens once investors have sold the stock.
It is most likely for investors to sell a stock when they have made a profit but experienced some recent setbacks in the stock. They have made good experiences but held the stock too long, so when they buy the stock back they tend to watch the basket of eggs even more closely. This way, it seems, they are trying to avoid the lost return from holding the stock for too long. But what they effectively do is teach themselves to become short-term traders. Every time they buy the same stock again, the average holding period declines by about 11%.”
So why do investors do this? Why do their holding period for the same stock progressively fall every time they buy it again? “Unfortunately, by watching their stocks more closely, they are more likely to react to short-term noise. As they try to anticipate the next correction, the returns of their stocks become smaller and smaller. The chart below shows the annualised alpha relative to the market for every roundtrip. Because every roundtrip becomes shorter and shorter, one would naturally expect the alpha to become smaller, but the annualisation guarantees that this effect is compensated for. And yet, every time they buy the same stock again, the performance relative to the market declines.”
The blog then goes on to show when investors stop behaving this – when they stop making money from making these round trips.