Out-classed: How mum-and-dad investors are beating the professionals
New research shows that individuals can make better traders than institutions
Peter Swan thinks mum-and-dad investors have been maligned for far too long – and he has the numbers to prove his case.
In the research paper, Other People's Money: Mum and Dad Investors Versus the Professionals, the UNSW Business School professor of finance and his co-authors – Wei Lu, also from UNSW Business School, and Joakim Westerholm from the University of Sydney Business School – analyse data covering almost the entire equity portfolios of every investor on a daily basis in Finland during a 17-year period.
The trio believes the study is a first in that they examine the matched trades between entire investor classes, covering households, domestic institutions and foreign institutions.
And the result? "We demonstrate that households are the winners against all opponents, followed by domestic institutions, with foreign investors always the losers," the authors state in the paper.
Furthermore, they find that households that do not delegate all their equity investment to professional managers are likely to be the most successful long-term traders.
According to Swan, the analysis shows that mum-and-dad, or individual, investors have been "unfairly treated for the past 35 years or more" through biased research and commentary.
"There seemed to be a whole industry devoted to denigrating households, saying they lack sophistication, make poor investment choices, are subject to endless psychological biases, and trade too much," Swan says.
And yet, it was so-called "sophisticated market participants" – largely hedge funds – which "actively purchased technology stocks during the (high-tech) run-up and quickly reversed course in March 2000, driving the collapse", according to research published in The Journal of Finance in 2011 ('Who Drove and Burst the Tech Bubble?').
Similarly, foreign institutional investors were the most active buyers in the communications giant Nokia (in Finland) when its price rose by almost fifty-fold during the internet bubble period, and then they actively sold during the subsequent downturn.
Ignoring the facts
Gerald Garvey, a Sydney-based managing director of BlackRock, the world's largest asset manager, is not surprised at the findings. Other studies over the years, he notes, have highlighted the prowess of individual investors.
'Households behave in a highly rational, market-stabilising fashion, buying when prices are falling and then selling when prices are rising' – peter swan & co-authors
Garvey says there is a subset of academe – led by the likes of American behavioural finance economists Brad Barber and Terrance Odean, who have long been critical of mum-and-dad investors – that is resistant to "accepting a completely obvious fact, which is that individual investors when they trade on their own tend to trade as contrarians and tend to do pretty well".
"And there's pretty much an incentive because some people have actually built their academic careers on the claim that individual investors are foolish – and it's just palpably untrue," Garvey says.
In the hope of taking the debate to another level, Garvey urges researchers to pursue three other big questions: how do individual investors achieve such good results; who comes out on top between those who engage in frequent trading versus a buy-and-hold approach; and why do individual investors typically abandon their contrarian streak when they hand their money over to institutional investors and become trend chasers?
"Are these different people from those that trade individual shares?" Garvey asks. "And should people also be contrarians in picking institutions?"
'It would be really cool if academics would stop arguing about behavioural school versus some other school and start asking: Well, what are these guys doing?'GERALD GARVEY
Swan, Lu and Westerholm use a new methodology which they dub the holding-period-invariant (HPI) portfolio approach, rather than the conventional calendar-time portfolio approach.
Swan says the latter imposes an assumption that all investors mechanically trade their portfolio at specified intervals corresponding to an assumed horizon. By contrast, the HPI methodology utilises the actual trades of households and their matched counter-parties.
As an indication of the impressive trading performance of individual investors, the researchers found that domestic households trading directly with foreign institutional investors outperformed them by €4.92 billion in just one stock alone, Nokia, over 17 years.
This represents an internal rate of return of 42.8% per annum for households trading with foreign-delegated money managers. Swan and his co-authors argue the finding is contrary to some, if not all, the existing empirical literature on mum-and-dad investors derived from calendar-time portfolios.
They also conclude that households behave in a highly rational, market-stabilising fashion, buying when prices are falling and then selling when prices are rising.
This "contrarian" strategy implies that, on average, households adopt an informed trading strategy. Foreign investors, on the other hand, typically trade far more frequently and are trend followers who rely on market momentum.
Domestic investors, both households and local financial institutions, display a sizeable "home information" bias, indicating that there are problems particularly with foreign institutional investors which invest in markets they do not fully understand.
The home bias in investment seems to be found almost everywhere and it is a brave investor who flouts his informational advantage.
Garvey believes one of the most remarkable aspects of the Finnish data is that it reveals that individual investors began selling off stock in 2007 – in advance of the global financial crisis that hit a year later – when many institutional investors were still content to buy and were even wary of missing out on supposedly desirable trades. The individual investors then started buying back into the market early in 2009.
"That's really impressive because that was a terrifying time to think about aggressive investing," Garvey says.
For his part, Garvey hopes the focus now switches away from a debate around which investors are best: individuals or institutional. There should simply be acknowledgement that individual investors are, on average, very good at what they do. The key is to devote more research into understanding the forces at play which allow them to perform so well.
"It would be really cool if academics would stop arguing about behavioural school versus some other school and start asking, 'Well, what are these guys doing?'"
Swan says the research paper delivers key lessons for Australian investors, Treasury and the regulators - the Australian Securities & Investments Commission and the Australian Prudential Regulation Authority.
First, judging by the Finnish evidence, many Australians who manage their own portfolios without delegating to professional managers will outperform their professional alternatives.
Swan adds that sizeable management fees paid by investors in both industry and professional or commercial superannuation funds is in part a product of the lack of alternatives and barriers placed in the way of self-managed funds.
ASIC and the other regulators, he suggests, can do more to promote access and competition. When put to Australian fund managers at a recent workshop, few fund managers questioned the basic premise in the paper.
Rather, they thought it unfair to compare households with fund managers as the former have some advantages – they are free to take their own risky long-term positions, are not forced to accept investment flows, and are not subject to externally imposed mandates.
Second, Swan notes that Australia's imputation system, which has been in operation since 1987, has served the nation well by removing double taxation at the company and personal level.
Despite this, Treasury appears to be considering amending or abandoning the system in the hope of encouraging greater internationalisation, creating a scenario whereby more foreign investors are likely to invest in Australia and more Australians will invest abroad to get alleged diversification benefits.
This, according to Swan, would remove the advantage that Australians have in investing in Australia by taxing them twice, once at the company level and again at the personal level. Such a move, he claims, would destroy much of the retiree incomes of Australians.
"And that's related to Treasury having the mistaken idea that investing in Australia by Australians is bad."