Why Experience Matters
|October 9, 2012||Posted by Oddmund Grotte under trading topics|
I believe experience is the most important asset for any speculator. It’s simple: the longer you survive, the fitter and stronger you get, and thus more fit to prey on other weaker players in the market. Experience will minimize overconfidence and ego. The markets are just like Darwin’s theory. But do individual investors learn from their mistakes?
By chance I came across this research paper from Germany: Do individual investors learn from their mistakes? You can read it yourself but I’ll copy the conclusions here:
Motivated by empirical evidence which suggests that individual investors tend to make various investment mistakes that, in aggregate, lead to significant social costs, this paper examines whether investors actually learn from their mistakes. To address this question, we use a large administrative dataset which covers the complete trading history of 19,487 German retail investors over a period of eight years. We exploit the dataset’s panel structure to explore the relationship of three well documented investment mistakes – underdiversification, overconfidence, and the disposition effect – with three different measures for investment experience.
We find that underdiversification and the disposition effect do not decline as investors gain investment experience. However, our results also show that gains in experience are associated with less portfolio turnover, suggesting that investors learn from overconfidence. We find that a gain in experience equivalent to 100 additional trades is associated with a decline in monthly portfolio turnover of 0.8 percentage points, which is a significant reduction considering that the average investor in the sample has an active portfolio turnover of 16.2% per month. Our findings are robust to the inclusion of various control variables in the regression specification, including investor and year fixed effects, as well as measures for changes in the market environment and investment style. Furthermore, a number of additional robustness checks highlight that our results are not driven by investor attrition, investors with prior experience, or outliers in the sample. We conclude that compared to underdiversification and the disposition effect, it is relatively easy for investors to identify excessive trading activity, understand the nature and resulting costs of the mistake, and avoid it in the future.
By correlating investment experience with portfolio returns, we are able to confirm the finding of previous studies that as investors gain experience, their investment performance improves. A comparison of portfolio returns before and after accounting for transaction costs reveals that the increase in portfolio returns is indeed related to learning from overconfidence. In light of the significant underperformance of individual investors, our findings suggest that learning from investment mistakes helps individual investors to close to some extent the performance gap to the overall market.