Cognitive bias and individual stock traders

Repeating yesterday's theme of cognitive bias, here's an article in the "Deal Professor" column of the New York Times illustrating herd behavior and loss aversion among individual investors. Steven M. Davidoff writes of individual investors that a study

found that the 20 percent who traded most actively earned 7 percentage points a year less than the buy-and-hold investors, the 20 percent who traded least actively. For the individual investor, that can add up to hundreds of thousands of dollars over a lifetime.

This is not surprising. Even mutual fund managers have trouble beating the market. Last year, according to S.& P. Indices, 84 percent of actively managed funds did not beat the Standard & Poor’s index representing that fund’s sector. Going back over five years, 61 percent of funds underperformed. Even so, most mutual funds beat individual investors who try to do it themselves.

If the professionals have such problems, individual investors don’t have a chance. They are not as knowledgeable and not as disciplined. Study after study has found that individual investors have a disposition effect — that is, they tend to sell winners too soon and hold on to the losers by refusing to recognize their failure.