In defense of individual investors

The vast majority of research on individual investors’ performance gives a depressing view. The conclusion is usually that individual investors hurt themselves by their trading, and would achieve higher returns adopting a more passive buy and hold strategy. This implication is often incorrect, and many of the studies need to read critically to understand exactly what they are saying.

I think there are three implied questions which are answered by these studies:

1. Is it possible for individual investors to beat the market?
2. Are the investment decisions individual investors make sub-optimal in some consistent way?
3. What is the implied “natural transaction” cost which an individual investors’ portfolio would experience?

Most studies focus on (1), and find underperformance of some kind. They then look to (2) to explain the under-performance, and ignore or “assume away” (3). As someone who is an individual investor, and who is close to the literature, I see (3), the inherent frictions of the market, as undermining most results. Most studies use a continuously compounded, total returns index as a benchmark to compare individual investor performance to. This means that dividends are immediately and costlessly reincorporated into the portfolio, and there are no ongoing costs to investment. This is a Platonic ideal of an investment option which simply isn’t available for individual investors. An investor who allocates their whole portfolio in an index-tracking ETF which distributes dividends will have negative alpha, by definition

• There will be the ETF’s fees, which will reduce the expected return of the investments by about 30-60 basis points per year.
• The ETF will have tracking error, which implicitly is additional volatility with slightly lower expected returns.
• The dividends generally cannot, and indeed should not be re-invested immediately. For an individual with a $50,000 portfolio with 4% dividend yield per year, distributing quarterly, reinvesting $500 of dividends quarterly at a fixed transaction cost of $20 results in annual drag of -4% on the compounding effect. Reinvest semi-annually, and you reduce that drag to -2%, but your cash will have spent time out of the market, essentially in a zero yielding asset. Underperformance persists.

An interesting implication of this is that any individual investors who matches market performance must actually be skillful.. They are overcoming the natural drag in the markets in order to simply stay abreast of a high standard. All of that said, there are studies which do study minutely the decisions of individual investors, and find specific behavioral biases which cause the drag. But that’s a post for another day. Today, I just wanted to make the point that in order to convict the average, experienced individual investors of mis-trading, we need to make sure we’ve identified them, and that we’re using a reasonable standard they could achieve, given their portfolio size.