Don’t Chase the Bus
“Never run after a bus or a stock. Just be patient — the next one will come along for sure.”
André Kostolany
André Kostolany was a Hungarian-born stockbroker who prospered during the reconstruction of Germany after WWII. He was known for his pithy insights into investors’ behavior, and his pragmatic understanding of the equity markets. In his writing, he often refers to the dynamic between steady, seasoned investors, who are willing to buy when the price goes down, and anxious amateurs, who are more likely to sell in a panic. He believed that it’s important to understand your own biases and limits as an investor, and to acknowledge the risks inherent in trading: “Always be fearful, never panic.”
Mr. Kostolany understood that managing our emotions is a crucial skill if we are to be effective in managing our investments. His investment demeanor depended on steady nerves and patience, as well as a willingness to accept losses and move on. He saw trading as a necessary tool for building wealth, rather than a way to create wealth. While the mechanics of stock trading have evolved considerably since Mr. Kostolany was trading, we still see an interplay between those who invest systematically (typically institutions), and those whose investment decisions are more emotionally driven.
In today’s equity marketplace, we see a confluence of factors that may encourage people to trade excessively. For example, equity trades are now free of charge at most of the discount brokerages, so you don’t pay a commission cost per trade. For some people, this means there’s no reason not to trade as often as you wish, at least in tax-deferred accounts such as IRA’s. In a taxable account, we may see higher tax bills as a result of frequent trades.
However, research by Brad Barber and Terrance Odean (UC Davis Graduate School of Management and Haas School of Business, UC Berkeley, respectively) shows that even without commissions or tax consequences, individual investors tend to have poor investment performance when they trade too much: https://faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20of%20individual%20investors.pdf
What drives investors to trade excessively? According to Kent Daniel of Columbia University’s Graduate School of Business, overconfidence bias among individuals as well as asset managers leads them to trade aggressively, even when such trading results in higher risk portfolios with lower returns. He found that overconfidence has been observed among financial professionals, including professional traders and investment bankers, as well as financial advisers.
Overconfidence bias can be described as a mistaken belief in one’s superior ability to analyze and profit from market trends, as well an illusory belief in one’s ability to control outcomes, which leads to excess risk-taking. A 2006 study of financial professionals by James Montier found that 74% believe they are above average in their analytical abilities, and the rest believed they were at least average – a statistical impossibility. These data suggest that most of the financial professionals who think they are above average are demonstrating overconfidence bias. Could your advisor be one of them? Pay attention to any promises that seem unrealistic. Be wary if your advisor suggests that they can simply avoid down markets, or have a strategy where risk is limited and the upside is tremendous. This is simply not how the market works over the long term.
We also find overconfidence among inexperienced investors. In the first quarter of 2020, discount brokerages saw significant year-over-year increases in new accounts opened, in some cases over 150% increase in new accounts from the first quarter of 2019. Newer online platforms like RobinHood appeal to younger investors with an interface that feels like a video game, and zero trading fees that have disrupted the marketplace. In the face of this competitive pressure, Schwab merged with TDAmeritrade, and both firms dropped trading fees to zero, making up lost revenue with payment for order flow (for more information on this practice, see https://empowermentfinance.com/blog/payment-for-order-flow-what-is-it-who-does-it-why-it-matters/).
These trends mean that our equity markets are increasingly attracting people who tend to be very active traders, rather than investors. The newcomers have not yet been called upon to demonstrate the patience and discipline that long-term investing requires. If we apply the wisdom of Mr. Kostolany, they tend to behave as anxious amateurs, selling in a panic when the market falls and missing opportunities on the way back up. Unfortunately, many investment professionals fall prey to the same unconscious bias as the newcomers: overconfidence.
“I can’t tell you how to get rich quickly; I can only tell you how to get poor quickly: by trying to get rich quickly.” André Kostolany
