Are Individual Investors Stupid?

Eddie Braverman's picture
Rank: The Pro | 21,126

Is the average American investor an idiot? I found myself pondering that question yesterday as I tried not once, but twice (unsuccessfully, I might add), to edge myself into some DXD calls between the spread. This is a trade I've already been burned on three times in the past 9 months. And by burned, I mean the options expired worthless. 100% loss. Three times now. And I'm trying it again.

Paul Farrell wrote this piece a couple months ago, and it has rattled around inside my head since then. He says Wall Street looks at the investing public as a bunch of "predictably stupid losers" and has already factored the public's predictable irrationality into its quant trading models. Farrell believes Wall Street regards individual investors as little more than prey.

Recently I explained why the Wall Street banks must kill financial reform to preserve their multibillion dollar bonus pool. One reader commented: "I worked at the Bear Stearns . . . every word written here is true. Fact is, bankers regard themselves as wolves and the public as prey, and speak about it openly among themselves." Then he added a sucker punch: "What is extraordinary to me is how willingly the sheep submit to this."

Back when I was trading professionally, I remember viewing individual investors with derision. At the time, I thought it was because I was privy to resources, systems, and information that they couldn't possibly be, so I likened their strategies to throwing darts at a board. The game was already beginning to change at that point (late 90's), but today I have to believe that individual investors don't have a prayer.

I have a friend who is a legitimate day trader, working from his home. He tells me that freq trading has all but put him out of business. Where he used to be able to scalp a quarter or even a half, he's now lucky if he sees a nickel. The risk is quickly outweighing the potential reward. And he's a pro.

So my question is, can individuals make a buck on purpose in the market? I know there are all sorts of happy accidents, and I don't count those. I'm talking about old-school value investing. I suppose it's possible for someone to buy a value stock and hang on to it for twenty years and make a handy profit, but in the interim thousands of short-term traders have taken money out of the stock a hundred times over.

The market opens in three and a half hours, and I know it's going to find me tilting at the windmill of a vastly overvalued Dow once again. Maybe I'll get a fill today, and maybe it'll work out this time. Incidentally, I wasn't wrong the last three times, I was just behind when the clock ran out (as the saying goes). The market had a mini-collapse each of the three times I bet against it - it just happened a day or two after my options expired. The last time would have been a four-bagger for me.

I'm wondering what you guys think. Is the game completely rigged? Is the Street having a good laugh at Johnny Lunchbucket's expense? Am I a complete moron for betting against another obvious bubble when the Fed is clearly committed to keeping it inflated? Are individual investors really predictably stupid?

Comments (26)

Aug 5, 2010

I'm an individual investor. I have no formal investment experience. I invest my meager savings using a "value" method. When I think the market is overvalued, I get out completely these days (bond yields are pretty low and interest rates are too low to not worry about interest rate risk). Other times I'll go short if I see something really worth while with only a small percentage of my portfolio.

When I think the market is undervalued (was in May IMO) I use a stock screener, pick a list of low book value, low PE ratio, low Debt:Asset ratio, dividend paying stocks. I then read the financial statements (as best I can, I have a job too). I'll buy and hold until I get the return I am looking for, usually 3-12 months. Recently, I have also bought VXX calls when things start to look up again.

Not sure if this is a dumb strategy or not, but I have made a much better return than the SP so far using this strategy, particularly in the downturn. Part of my luck was thinking that the market was overvalued in the downturn and holding bonds when DJI was at 14,000. That was luck plus some statistics.

That said, my father probably would be better off with a dartboard.

Aug 5, 2010

It's pretty well documented that active individual trading is a losing strategy.

Aug 5, 2010

Yes, traders have a lot more tools at their disposal than your typical retail investor. As the chief desk developer, I'm one of the guys who helps keep things that way.

That said, the retail investor has a better idea of what typical consumers are doing than the average trader. Traders might have huge competitive advantages when it comes to trading rates products, commodities, or, say, a REIT, but when it comes down to Kimberly-Clarke, Johnson and Johnson- or even BP, I wouldn't be as comfortable betting against a retail investor.

Also, for all the disdain some folks pile on these guys, they were the ones who were buying back in March 2009 while all of the institutions were selling. The retail investors called the bottom while a lot of hedge funds and institutions were going bust- so maybe they're smarter money than we think.

There's a lot of smart people out there who invest but don't work in finance. You can call retail investors stupid if you really want to, but it's the height of stupidity to lack a healthy respect for your competition.

Aug 5, 2010
IlliniProgrammer:

Yes, traders have a lot more tools at their disposal than your typical retail investor. As the chief desk developer, I'm one of the guys who helps keep things that way.

That said, the retail investor has a better idea of what typical consumers are doing than the average trader. Traders might have huge competitive advantages when it comes to trading rates products, commodities, or, say, a REIT, but when it comes down to Kimberly-Clarke, Johnson and Johnson- or even BP, I wouldn't be as comfortable betting against a retail investor.

Also, for all the disdain some folks pile on these guys, they were the ones who were buying back in March 2009 while all of the institutions were selling. The retail investors called the bottom while a lot of hedge funds and institutions were going bust- so maybe they're smarter money than we think.

There's a lot of smart people out there who invest but don't work in finance. You can call retail investors stupid if you really want to, but it's the height of stupidity to lack a healthy respect for your competition.

Good point. The nastiest trader I have ever met was a part time cartoonist. Obviously, he trades with a small account by WS standards but being nimble gives him speed and flexibility to do things big funds cannot. That's the great thing about markets, a smart, aggressive, yet disciplines player can do well for himself with only a high speed internet connection and low broker fees. Not for everyone, naturally. But it certainly can be done and is...right now...all over.

Aug 5, 2010

Stupid? I don't know.

Respectable: Probably not

Yours truly,
The Young Investor

Aug 5, 2010

When I think the market is undervalued (was in May IMO) I use a stock screener, pick a list of low book value, low PE ratio, low Debt:Asset ratio, dividend paying stocks. I then read the financial statements (as best I can, I have a job too). I'll buy and hold until I get the return I am looking for, usually 3-12 months. Recently, I have also bought VXX calls when things start to look up again.

That method is a good start, but you've also got to look at the 10Ks and 10Qs and understand how much safety margin you've got built in and WHY people are selling it at that price.

I find that it's easier to make money in the small caps. Some tiny company will be trading with a P/E of 4 with low leverage and $1.50 of equity for every $1 of stock price because some mutual fund manager has gone berserk and is dumping at ANY price.

Also, I'm trying to remember which experienced trader on this forum was saying BP was going to go to $0 back when it was at $28/share. Does anyone remember who that was? I think his named started with an E. Sometimes, the smart money gets it wrong, too, but hey, I'm sure their short positions are for the "long-term". :D

It's pretty well documented that active individual trading is a losing strategy.

I dunno. My plan was to find illiquid small caps with a larger float than the spread justified and start dealing on them with an interactive brokers account if I ever got laid off.

Aug 5, 2010
IlliniProgrammer:

Also, I'm trying to remember which experienced trader on this forum was saying BP was going to go to $0 back when it was at $28/share. Does anyone remember who that was? I think his named started with an E.

HA! Touche. Still wouldn't touch it with a ten foot pole, though.

Thanks for the chuckle.

Aug 5, 2010
IlliniProgrammer:

When I think the market is undervalued (was in May IMO) I use a stock screener, pick a list of low book value, low PE ratio, low Debt:Asset ratio, dividend paying stocks. I then read the financial statements (as best I can, I have a job too). I'll buy and hold until I get the return I am looking for, usually 3-12 months. Recently, I have also bought VXX calls when things start to look up again.

That method is a good start, but you've also got to look at the 10Ks and 10Qs and understand how much safety margin you've got built in and WHY people are selling it at that price.

I find that it's easier to make money in the small caps. Some tiny company will be trading with a P/E of 4 with low leverage and $1.50 of equity for every $1 of stock price because some mutual fund manager has gone berserk and is dumping at ANY price.

Looks like someone else has actually READ Benjamin Graham's Intelligent Investor with me. Yes, my mistake, I misspoke, I meant 10K and 10Q. I got burned for not being thorough already today (read: Manulife Financial) but I have seen success from large and medium cap equities alike (read: Molson Coors and Kaiser Aluminum). Your advantage with small cap stocks is real however, the big guys can't always invest in that stuff.

Aug 5, 2010

Given all the quant models/algorithms/"illiniprogrammers" out there, it is definitely pointless to try and trade for quick short term gains. To be somewhat competitive in the short-term, you need to have a solid understanding of finance, a strong quantitative skillset, a TON of time on your hand, and manage emotion very well. Too much work in my opinion, and even if you have all this the odds are still stacked very high against you.

Personally, I am young, have a ton of cash (relative to my age group), and don't spend it on models&bottles. I like to park my cash, for long hauls, in large-cap companies that , I believe, provide services/products that the average adult/child is definitely going to want. Quants/algorithms/recessions might have made apple's price fluctuate over the last two years, but apple offered products with high demand and the stock price went from ~$180 to ~$260.

In my opnion, understanding finance and having a feel for what consumers want makes fundamental investing with a long hold strategy the way to go these days.

Aug 5, 2010
zip:

Personally, I am young, have a ton of cash (relative to my age group), and don't spend it on models&bottles.

What is a ton of cash in one's early 20s these days?

Aug 5, 2010
MonkeyMath:
zip:

Personally, I am young, have a ton of cash (relative to my age group), and don't spend it on models&bottles.

What is a ton of cash in one's early 20s these days?

For me, being able to put about $25K in the market for a long hold, and having way more than that in my savings account in case I get laid off.

Aug 5, 2010

Well said.

Aug 5, 2010

I think all trading strategies and trading groups are susceptible to the wrath of ever changing market conditions (i.e. LTCM, Amaranth, Aunt Betty, etc.). Bear Stearns HFs that blew up, Lehman...were these guys any better than the average investor?

Sophisticated retail investors have the distinct advantage of being nimble (smaller AUM) and have access to all of the requisite information to make educated value investing decisions. If you dont have the time or inclination to do the actual work you should be putting your money in low cost index funds.

Aug 5, 2010

Quotes from Margin of Safety by Klarman. He convinced me Wall Street is dumber than the average investor but that means the average investor has to do HW and find "value". My background is PE so I hate short term trades... If you can't stand volatility, get out of the market...

"The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it."

"The future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survey and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his of her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity."

"To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that "in any sort of a contest -- financial, mental or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try." I believe that over time value investors will outperform the market and that choosing to match it is both lazy and shortsighted."

"Warren Buffett likes to say that the first rule of investing is "Don't lose money," and the second rule is, "Never forget the first rule." I too believe that avoiding loss should be the primary goal of every investor. This does not mean that investors should never incur the risk of any loss at all. Rather "don't lose money" means that over several years an investment portfolio should not be exposed to appreciable loss of principal. While no one wishes to incur losses, you couldn't prove it from an examination of the behavior of most investors and speculators. The speculative urge that lies within most of us is strong; the prospect of a free lunch can be compelling, especially when others have already seemingly partaken. It can be hard to concentrate on potential losses while others are greedily reaching for gains and your broker is on the phone offering shares in the latest "hot" initial public offering. Yet the avoidance of loss is the surest way to ensure a profitable outcome."

"Frequent comparative ranking can only reinforce a short-term investment perspective. It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term performance, the long-term view may well be from the unemployment line ... Relative-performance-oriented investors really act as speculators. Rather than making sensible judgments about the attractiveness of specific stocks and bonds, they try to guess what others are going to do and then do it first."

"Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing."

"Wall Street can be a dangerous place for investors. You have no choice but to do business there, but you must always be on your guard. The standard behavior of Wall Streeters is to pursue maximization of self-interest; the orientation is usually short term. This must be acknowledged, accepted, and dealt with. If you transact business with Wall Street with these caveats in mind, you can prosper. If you depend on Wall Street to help you, investment success may remain elusive."

"Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost assures it."

Aug 5, 2010

I think it comes down to core competency. Individual investors are investing as a hobby. They typically do no have advanced educations in the subject, years of work experience or access to all the best tools (Bloomberg, CapIQ, Industry Resources). They also do not realize how much programed trading can sell things off or run up the price. A trader looking at order flow and knowing certain funds are buying or whatever is in a much better position then the average joe schmoe.

Plus look at transaction costs. Even low cost brokers are not free. Add to that that the majority of Americans who trade frequently are following bullshit tips, watching talking heads on TV or just following their gut. They are sheep.

Index funds are the average American's best friend.

Aug 30, 2012
TNA:

I think it comes down to core competency. Individual investors are investing as a hobby. They typically do no have advanced educations in the subject, years of work experience or access to all the best tools (Bloomberg, CapIQ, Industry Resources). They also do not realize how much programed trading can sell things off or run up the price. A trader looking at order flow and knowing certain funds are buying or whatever is in a much better position then the average joe schmoe.

Plus look at transaction costs. Even low cost brokers are not free. Add to that that the majority of Americans who trade frequently are following bullshit tips, watching talking heads on TV or just following their gut. They are sheep.

Index funds are the average American's best friend.

Very good points. Much better than saying they're just stupid.

Because when you're in a room full of smart people, smart suddenly doesn't matter--interesting is what matters.

Aug 5, 2010

It is worth noting that relative to normal, retail investors are very lightly invested in stocks right now and have actually been piling into bond funds agressively for quite some time. So far they have done quite well. I also dispute the idea that index funds are anyone's "best friend"...the indices have returned nothing over the last decade. Government bonds would have been the average American's best friend had they been invested in them over this time period. And now the public is finally piling into fixed income when the dividend yield of the S&P is higher then the yield on the 5yr note. If we have a total Japan/deflationary bust scenario they will get paid, but any other outcome and this will be the classic case of "mom and pop" arriving late to get their collective clocks cleaned as a bubble bursts.

Aug 5, 2010

Suprised to see no chartists here.....

Aug 7, 2010
lifesavings:

Suprised to see no chartists here.....

If you use charts/candlesticks properly, you win.

It's simple.

You see what the smart people are doing essentially instantly, how the market reacts, and all the signs to be careful of.

Look at the dow on Friday. Below average news on jobs, and we still closed near the highs of the day.
Now, look at the chart. Coincidence? It fell below the 10 and 100 day MA's (and almost hit the 150) and bounces up SHARPLY. Bulls aren't done yet. We close below this, and expect a nice decline (a few hundred points).
FYI - Hanging man move. Signifies potential danger to bulls.

Fundamental analysis is for fools, with all due respect. People loved C @ 20. It's now $4. People loved GE at $40. It's now $17.

For you fundamental analysis people.... Can you please confirm this for me... Whenever I see a firm's positions regarding buy, sell, and hold, I feel like they have the majority in Buys... Is this my imagination? How can >50% of the market outperform...

Aug 5, 2010

Index funds all the way. I'm planning on putting a small % of money to work in value investing at some point, but don't see any point in actively trading. It's a losing proposition most of the time.

Aug 6, 2010

Edmundo, I am suprised you are asking this.

Quite frankly, the individual investor is stupid. I am not saying that there are smart or dumb investors, but the group, as a whole, are stupid, and not for the reasons you may think. This is why the high end and boutique money management shops make more money by providing individual investors access to managed accounts and hedge funds than they do trading stocks and bonds for most clients. Having dealt with individual investors, the biggest problems are lack of knowledge, which was already mentioned, and who they are trading against, which wasn't. It's not a question of tools available, because the shop I work at provides clients the same level of access to our trading systems (ie if I worked at Goldman, all of our trades would be executed on the same SigmaX platform that the rest of the firm uses), but that they are competing against, of all things, a rigged market. With the influx of HFT and millisecond trading/frontrunning, you tip the NBBO away from benefiting everyone to benefiting the HFT guys since they are changing it ever so slightly and coming in ahead of everyone else when it comes to execution. I deal with smaller Hedge Funds (So much nicer than the big guys) and they have been complaining about their inability to compete with all of these prop HFT shops for domestic trading, as it's harder and harder to get the fill you want. If they can't get filled properly, the individual investor has an even smaller shot at it. It's really a sad thing, ya know.

Lifesavings, chartists and technical specialists have a place in the world. Most individual investors don't, because to them it's more voodoo than science. I believe that a mixture of due diligence and chartography works wonders if you want to try and make money short term, but the reality is, this is not a market you want to trade short term in unless you're focusing on day trading levered ETFs or have both the capital and access to the right trading platforms and can stomach the overnight risks.

Aug 7, 2010
Frieds:

Lifesavings, chartists and technical specialists have a place in the world. Most individual investors don't, because to them it's more voodoo than science. I believe that a mixture of due diligence and chartography works wonders if you want to try and make money short term, but the reality is, this is not a market you want to trade short term in unless you're focusing on day trading levered ETFs or have both the capital and access to the right trading platforms and can stomach the overnight risks.

Technical analysis and charting is less risky. If you do it the right way, sure you'll take some losses. But you'll also take some profits. Overnight risks are part of life. If you can't stomach that, don't invest.

Create a set of rules, i.e. if a holding closes below X amount, you sell and take the loss. Otherwise, you take your profit when you're ready to or wait until the chart tells you sentiment is changing.

Aug 6, 2010
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"Salesmen and traders are wild, cunning, aboriginal creatures who advise money managers about deceiving their bosses and finding new strip bars; their favourite phrase is, "Fuck you." IBankers eat fruit. Salesmen and traders eat meat, preferably fried."

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