The better you know a company, the worse you do at trading its shares. And the more you trade the poorer you become, an interesting new study, with broad implications for passive investing, has found.
Common sense tells us that you should not buy shares in a company unless you know something about the company. After all, stock markets are competitive. And in such a setting, it is reasonable to think that the most experienced and knowledgeable traders will do better than the most ignorant and inexperienced.
Passive investing, the same common-sense view holds, is best left to people who are time-poor or lacking superior knowledge.
Frequent trading leads to shorter time horizons and worse results. Source: Ellapulli Vasudevan
But this common-sense view is wrong – and the opposite is closer to the truth, the study entitled “Familiarity Breeds Short-Termism”, has found.
Aussie ETF trading costs explode
The study looked at the trading accounts of every retail investor in Finland over a period of 20 years, from 1995 to 2014. It investigated which companies’ shares retail investors traded and at what prices. Data was taken from the Finnish registry of shareholdings.
No-one knows how to time the market. Source: Ellapulli Vasudevan
It assumed that knowledge increased over time, and that traders got to know more about companies’ whose shares they held for longer periods and traded often.
It then calculated investors’ success per trade – and whether investors became more successful as they traded more.
The study found that there was no discernible trading advantage accrued by those who held superior knowledge about a stock. On the contrary, there was evidence that frequent trading led to progressively worse results.
Investors adopting a short-term mindset was the cause of the worsening results, the study found. When investors felt themselves more knowledgeable about a company, they felt more comfortable trading it more frequently. And this short-term mindset was not conducive to successful investing.
“Investors become short-termed as they become more familiar with trading a stock…familiarity is associated with investor short-termism,” it concluded.
More damningly, the study found there was no evidence that trading skill existed at all. At least in the study’s Finnish sample.
“[There is] no clear evidence of investors learning to time the market and trade skilfully in a stock,” it said.
The study adds to a growing body of literature that finds that trading makes investors in aggregate poorer. And adds to evidence suggesting that investors are better off in passive market-weighted index funds – such as total market ETFs – that avoid trading entirely.
Sign up to ETF Stream’s weekly email here
