Learn about investing – or leave it to the pros

Research shows that retail investors are prone to simple yet costly mistakes, which cause them to underperform the market and investment professionals significantly.

Many investment platforms promote retail investing as an easy way for people to create wealth and make their money work for them.

It is true that the stock market, and hence investing in shares, produces higher returns than other investments like bonds, property, or money markets.

However, picking the right shares or knowing when the right time is to buy or sell is not trivial.

Many retail investors think reading a few Twitter posts and getting a tip from a friend is enough information to make a decision. The results are telling.

Researchers analysed all stock transactions executed by the universe of individual investors, also known as retail investors, of the Colombian Stock Exchange.

It found that the average individual investor biases his portfolio toward small, low-beta, and value stocks and turns over approximately 8.8% of his portfolio monthly.

This strategy resulted in retail investors experiencing significant losses. When transaction costs were considered, the underperformance of retail investors became even more pronounced.

It further found that the most active traders performed worse than less active traders, even on a gross excess return basis.

The underperformance of retail investors can be explained by their bad timing – they buy and sell stocks at the wrong time and do so far too often.

Notably, the researchers found that investors with more experience in the market could earn higher gross and net returns.

Institutional investors also performed better than retail investors. Although they underperformed the market, it was at a less severe level than that recorded by individual investors.

Retail investors also suffer in the bond market

Research by Stanford’s Graduate School of Business found that retail investors also make simple yet costly mistakes when trading corporate bonds.

The researchers explored an extensive dataset of United States corporate bond trades from 2002 to 2019.

They found that retail investors often treat credit ratings as comprehensive indicators of credit risk.

They trade as if bonds within the same rating, like AAA, are similar, inadvertently overlooking that the financial health of firms with the same rating can vary widely.

Although retail investors generally prefer safer-rated bonds, they tend to choose riskier ones within each safety rating.

These investors tend to disregard the well-known fact that unusually high bond yields signal heightened risk.

Yet, they aim to maximise their potential profits by buying bonds with high yields and selling those with lower interest rates.

“These behavioural patterns correlate with significant underperformance,” the Stanford researchers said.

The study concluded that had retail investors opted for index funds rather than hand-picking corporate bonds, they could have collectively saved over $1 billion in 2019 alone.

The researchers suggested that retail investors will be better served by investing in low-cost index funds that distribute capital across a range of bonds.

“It will avoid this pattern of systematically buying and selling the wrong bonds. And it will lower the transaction costs on each bond,” the researchers said.