Academics have found that people tend to overrate their abilities. Survey a group of people and chances are, the majority will say they are better than average at some skill. For example, Svensonsurveyed a group of car drivers andfound a majorityregarded themselves as more skillful than the average driver.
This same psychological tendency toward overconfidence is said to afflict active investors (at least before the bear market of 2008 came along). And like other groups, the tendency toward overconfidence leads to greater risk taking, which in the stock market manifests as over-trading and under-diversification.
Over-trading: Barber and Odeanpublished a 2000 paper that examined the trading histories of 60,000 U.S. investors at discount brokerages between 1991 and 1996, segmenting them into five groups according to frequency of trading. They found each quintile earned nearly the same gross return, but when trading costs were factored in, net returns went down as trading activity went up.
Under-diversification: A 1995 research paper by Morganlooked at the portfolios of over 3,000 U.S. individuals. Of those invested in stocks, one-stock portfolios were most common. Only 5 per cent held more than 10 stocks.
(Thanks to Richard Deaves’ book ‘What Kind of an Investor are You” for pointing out these studies).