Higher levels of confidence about one’s ability to invest leads to worse returns. I realize that this may seem counterintuitive to some of you, but this is the conclusion of a study accepted by the Journal of Behavioral and Experimental Finance (an earlier version of the study is available on SSRN). It’s yet another example of how our brains can be harmful to our portfolios.

The researchers accessed the brokerage records and demographic data for clients of the largest discount broker in the Netherlands. Brokerage statements were matched up with the results of monthly surveys measuring investors’ confidence. One advantage of studying Dutch investors is that there are no capital gains taxes in the Netherlands, therefore eliminating the influence of tax-loss harvesting decisions. The sample period was April 2008 through March 2009. Authors Arvid Hoffman and Thomas Post of Maastricht University say the high level of volatility that occurred during this period was “beneficial” for their analysis.

Those investors with above-average levels of confidence traded more. Their average monthly turnover was 8.6% higher than investors with below-average confidence. The most confident investors traded even more frequently, with 10.3% greater turnover than other investors. This higher level of trading did not lead to better returns. Rather, the average monthly returns realized by investors with above-average confidence were 0.88% worse than the monthly returns for investors with below-average confidence.

Commenting on their findings, Hoffman and Post wrote, “Investor confidence is not correlated with superior skills. If we exclude from the model variables that are related to investor confidence, that is, return expectations (related to confidence when forming beliefs) and trading indicators (related to confidence as confidence triggers trades through changing beliefs), investor confidence has a significantly negative impact on investor returns.”

Naïve reinforcement learning drives the higher trading. Positive experiences increase the odds of an action being retaken, while negative experiences decrease the odds. Some of you might be more familiar with the concept from sayings such as “the worst thing that can happen to a gambler is to win his first bet” or “the worst thing for an investor is to have the first investment be profitable.” Initial or early success can cause a person to confuse skill for luck. What might be perceived as ability or a good trading strategy is just a favorable combination of luck and a lack of sufficient outcomes to draw a better conclusion from.

Confidence, in and of itself, is not a bad thing. It can give an investor the ability to adhere to a long-term strategy during volatile periods or when a strategy is out of favor (e.g., value stocks are lagging growth stocks). Too much confidence is a problem when it leads investors to change their beliefs and rely on intuition instead of data—particularly long-term data on what does and does not work.

• Trading More Frequently Leads to Worse Returns – One of the most cited studies about the adverse impact of making more transactions was conducted by Terrance Odean and Brad Barber. Terry discussed their findings in this November 2014 AAII Journal article.
  
• Think Twice, Even Thrice, Before Trading – A separate analysis by Mark Hulbert found that returns for many newsletters would have been higher if they had issued fewer buy and sell alerts.
  

• “Trusting Your Gut” Not Proven to Increase Returns – While gut feelings can provide valuable physiological signals, causation between those signals and greater profits are not proven.
  
• New Rules for Model Shadow Stock Portfolio, Including Momentum – Jim Cloonan discusses the rule changes he made to the Model Shadow Stock Portfolio.
  

The U.S. stock exchanges will be open on Monday, Columbus Day, even though it is a federal holiday.

The first “official” week of third-quarter earnings will feature four banks: Dow Jones industrial average component JPMorgan Chase & Co. (JPM) and fellow S&P 500 members Citigoup (C), PNC Financial Services Group (PNC) and Wells Fargo & Co. (WFC). All of them will announce their results on Friday. Also reporting next week will be S&P 500 members Alcoa (AA) and Fastenal Co. (FAST) on Tuesday, CSX Corp. (CSX) on Wednesday, and Delta Air Lines (DAL) and Progressive (PGR) on Thursday.

The week’s first financial reports will be the Labor Department’s August Job Openings and Labor Turnover Survey (JOLTS) and the minutes from the Federal Open Market Committee’s (FOMC) September meeting, both released on Wednesday. Thursday will feature September import and export prices and the September Treasury budget. The Bureau of Labor Statistics’ producer price index (PPI) final demand for September, September retail sales, August business inventories and the University of Michigan’s preliminary October consumer sentiment survey will be released on Friday.

Five Federal Reserve officials will make public appearances: Chicago president Charles Evans on Monday; Kansas City president Esther George on Wednesday; Philadelphia president Patrick Harker on Thursday; and Boston president Eric Rosengren and Chair Janet Yellen on Friday.

The Treasury Department will auction $24 billion of three-year notes and $20 billion of 10-year notes on Wednesday, and $12 billion of 30-year bonds on Thursday.

The percentage of individual investors describing their short-term outlook for stocks as neutral rose to a two-month high as pessimism plunged in the latest AAII Sentiment Survey. Optimism, though still low, rebounded to a four-week high.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 4.8 percentage points to 28.8%. This is the 48th consecutive week and the 81st out of the past 83 weeks with a bullish sentiment reading below its historical average of 38.5%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, jumped 4.4 percentage points to 43.3%. Neutral sentiment was last higher on August 3, 2016 (43.4%). The rise keeps neutral sentiment above its historical average of 31.0% for the 36th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 9.2 percentage points to 27.9%. The drop puts pessimism at a seven-week low. The drop also puts pessimism below its historical average of 30.5% for the first time in four weeks.

This week’s drop in pessimism is the largest weekly decrease since February 10, 2016, when bearish sentiment fell 10.9 percentage points. We have also seen big weekly increases this year, with pessimism rising by 14.0 percentage points on February 10, by 9.7 percentage points on June 15 and by 7.4 percentage points on September 14. The median weekly change (in either direction) for bearish, and bullish, sentiment over the life of the survey is about 5.0 percentage points.

The pullback in bearish sentiment occurred after pessimism hit 38.3% two weeks ago. A settling down of market volatility appears to have helped calmed the nerves of anxious investors. Nonetheless, some investors still have concerns about the possibility of the stock market experiencing a larger drop than what occurred in mid-September. Further adding to pessimism about the short-term direction of stock prices are concerns about valuations, global economic uncertainty and the pace of corporate earnings growth. Giving other individual investors reason for optimism are this summer’s rise in stock prices, the perceived lack of investment alternatives, corporate earnings, low/stable energy prices and sustained, albeit slow, economic growth.

This week’s special question asked AAII members how much influence the election is having on their expectations for the stock market relative to other factors such as earnings growth, the economy, the Fed, valuations, international factors, etc. Just under half of all respondents (49%) said that the election is either having just a small/minimal impact or no impact on their stock market expectations. Several said that other factors matter more. Nearly a quarter of all respondents (23%), however, said that the election is having a large influence. Many of these investors are bracing for a drop in stock prices, or at least increased volatility. An additional 5% say that the election is creating uncertainty and 4% said that the election is having some influence on their market outlook. We included the phrase “regardless of which candidate you support” in the actual question and most respondents did not state which candidate they favor.

Here is a sampling of the responses:

• “I believe the presidential election has less of an impact than the other factors you mention, earnings growth, the Fed, international factors, etc.”
• “Like the market, I’m not making a move until I feel comfortable with who the new president might be.”
• “I think the election will only have a short-term effect, if any.”
• “My expectations for the aforementioned factors will change with which party is in control.”
• “The election is creating uncertainty, which I view as a negative for the market.”
• “The election, a real disappointment to Americans, will likely trigger a downward slide to stocks.”

Bullish: 28.8%, up 4.8 points
Neutral: 43.3%, up 4.4 points
Bearish: 27.9%, down 9.2 points


Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%

Fixed-income allocations among individual investors fell last month to their lowest level in over a year. The September AAII Asset Allocation Survey also shows a decline in equity allocations and a rebound in cash allocations.

Stock and stock fund allocations declined 1.2 percentage points, to 65.4%. Equity allocations have now been above their historical average of 60.5% for 42 consecutive months.

Bond and bond fund allocations declined 1.1 percentage points, to 16.3%. Fixed-income allocations were last at this level on August 2015. Even with the decrease, fixed-income allocations remained above their historical average of 16.0% for the 14th consecutive month.

Cash allocations rose 2.3 percentage points, to 18.3%. Cash allocations had previously fallen for three consecutive months after having reached 19.3% in May. Even with the rise, cash allocations remained below their historical average of 23.5% for the 58th consecutive month.

There isn’t a clear reason to explain the drop in fixed-income allocations to a 13-month low. Yields on the benchmark 10-year Treasury rose during the first half of September, and our members have previously expressed concern about a drop in bond prices. Differences in who responded to last month’s survey from previous months may have also played a role. We send out weekly reminder emails to take our surveys to a rotating group of AAII members.

In general, individual investors are frustrated by the low yields on bonds, the low interest rates paid by savings and money market accounts, and the high valuations of stocks. Several AAII members have expressed that they see no good alternatives to stocks currently existing or have otherwise said that they feel like they are being forced to allocate more to stocks because of the current interest rate environment. At the same time, optimism about the short-term direction of stock prices continues to be low, according to our weekly Sentiment Survey.

This week’s special question asked AAII members what asset class (or classes) they would invest in today if given $50,000. Slightly more than half of all respondents (51%) said stocks. Dividend-paying stocks were particularly mentioned for their quarterly cash distributions. Growth and technology stocks were also favored. A few respondents said that there is currently no good alternative to stocks in the current environment. About 20% of respondents said stock funds (some respondents listed more than one investment in response to our open-ended question.) Cash was favored by 23% of respondents, with some saying they would wait until after the election to invest, though others said that they are expecting a drop in stock prices. Only 7% and 5%, respectively, said they would invest in bond funds or bonds.

Here is a sampling of the responses:

• “Dividend-paying stocks to take advantage of the income.”
• “I would invest in large-cap dividend stocks. There is nowhere else I can get growth, yield and a modicum of capital preservation.”
• “Cash. I’m expecting a market decline in the next six to 12 months and would invest the cash after a 10-15% drop.”
• “Technology, because that’s the one place where innovation and growth can be expected.”
• “Given $50,000 today, I would hold it in cash until after the November election.”
• “Short-term tax-free municipal bond funds. This meets my need to have some liquidity with a higher return than money market funds.”

• Stocks and stock funds: 65.4%, down 1.2 percentage points
• Bonds and bond funds: 16.3%, down 1.1 percentage points          
• Cash: 18.3%, up 2.3 percentage points

• Stock Funds: 34.4%, up 0.4 percentage points
• Stocks: 31.0%, down 1.7 percentage points
• Bond Funds: 13.3%, down 0.4 percentage points
• Bonds: 3.0%, down 0.7 percentage points

Take the Asset Allocation Survey.

Local Chapter Meetings