Study your errors

Last Updated: Sun, Dec 02, 2012 06:52 hrs

The Indian School of Business (ISB) has done a study mining data from the National Stock Exchange (NSE) to understand how retail investors think and operate. This exercise was massive in scope with the ISB tracking the trading habits and portfolios of 24.6 lakh retail investors who operated in the secondary market between January 2005 and June 2006.

During this period, the Sensex and the Nifty gained 60 per cent. It was the middle of the biggest bull run in Indian history. The bull market continued till January 2008. There was no big correction and the uptrend was broad with advances outnumbering declines across the entire market.

The sample tracked by ISB made about 140 crore trades with a total value of about Rs 37,00,000 crore (Rs 37 lakh crore) on the NSE. This included about 98 per cent of all equity trades. In value-terms, the retail segment accounted for around 36 per cent of the market value of all equity trades.

The losses for retail investors over this period amounted to about Rs 8,400 crore, net of brokerage, taxes, etc. That's right! During the biggest bull market in history, retail as a group made net losses. Since equities are zero-sum, they passed on their profits to institutions.

During that particular period, a simple strategy of buy and hold on almost anything should, on balance, have produced profits. Yet retail investors consistently bought and sold the wrong stocks at the wrong time. They sold winners early, and they held onto losses in what is called the disposition effect in behavioural economics. Disposition led to another well-documented phenomenon – over-confidence. When retail investors make money, they get over-confident and trade too frequently and also take unacceptable risks.

The study offers only partial coverage of retail behaviour though its rigour seems unquestionable. It focusses only on retail players, who were actively involved in the secondary market during the given period. They made around 4 lakh trades a day.

Given that frequency, a fair number of the individuals in the sample tracked by ISB would be better described as traders, rather than investors. The study probably doesn't capture the returns of long-term investors, who are less active. Some long-term investors may well have made money by sitting tight through 2005-2006 and thus slipping under the ISB radar.

However, the study does confirm that most of India's retail players are similar in behaviour to retail players elsewhere. Disposition effects and over-confidence go together and a third bias, loss aversion, also comes into the picture.

Retail players cash out winning positions early and hate booking losses. They tend to over-trade and take large risks when they are ahead, often without fully understanding consequences. They make some profits and promptly lose it all back. When they've lost money, loss aversion comes into the picture. They abandon the market or cutback exposure and miss out on opportunities.

None of this is news. Everybody makes these common mistakes sometimes. Even the best traders and investors have usually learnt what not to do from bitter personal experience. This is one reason why systematic strategies tend to offer better results. Having a system imposes discipline and rationality and tones down dangerously manic-depressive trading.

However, many people simply don't have the psychological make-up required to overcome biases. In 1983, two commodity traders in Chicago ran a famous experiment. They interviewed some 1,000 candidates and picked 23 traders. They gave these 23 an intensive three-week course in trading technique.

They imposed a system with simple rules distilled from their own experience. The "Turtles" as this group was nicknamed, were told for example, to buy on 50-day highs and sell short on 50-day lows, with strict stop losses and exit signals. The system wasn't all that brilliant. But the rules did eliminate behavioural biases.

Those who followed the system made large profits over the next four years and many of them went onto successful investment careers. But some of the Turtles simply couldn't maintain discipline. They broke the rules and delivered poor results.

About 4 lakh traders in the ISB sample – that is, roughly one out of every six individuals - made net gains. Some would have made large profits. The big winners would be the individuals who possessed the discipline to diagnose their behavioural biases and iron them out.

A study like this highlights the mistakes you shouldn't make. It's up to the individual to work out ways to avoid making those errors. Long-term success in the stock market is probably impossible without finding some way to cut down on biases.

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