The Impact of Experience on Performance
Individual investors adapt their trading strategies over time, but only partially learn from their mistakes. This is what three researchers concluded after analyzing the trading history of 19,487 German individual investors over an eight-year period.
The researchers used the data to test three hypotheses:
- As individual investors gain investment experience, they make fewer investment mistakes.
- Learning from investment mistakes is stronger for those investment mistakes that are easy to detect and avoid.
- An increase in investment experience is associated with an increase in portfolio returns.
They found that as experience increases, investors were likely to trade less often. The study’s authors rationalized that the impact of transaction costs on performance was easier to spot, prompting investors to trade less. The decline in trading is viewed as signaling an inverse relationship between confidence and experience. Investors are more confident about their abilities when they have less experience; as they trade more, they learn to recognize the limits of their abilities. (Overall portfolio turnover was not low, however, averaging 16.2% per month for all investors in the study.)
Diversification, however, did not increase with experience. Rather, individual investors stayed under-diversified. One previous study concluded that since investors like to brag to their peers about their successful investments, they tend to pick few stocks in hopes of achieving a noteworthy victory. This behavior leads to an active, but under-diversified, approach to investing.
Furthermore, the disposition effect (being predisposed to holding onto losers too long and selling winners too early) actually increased with experience. This finding contradicted previous studies, though differences in the sample periods made it difficult to compare the results.
The authors concluded that more experience does not lead to fewer mistakes. While investors do learn to reduce transaction costs, they do not learn from other mistakes. Part of the reason is that the ambiguous feedback given from actions such as not being properly diversified makes it harder to identify what mistakes are being made.
Source: “Do Individual Investors Learn From Their Mistakes?,” by Maximilian Koestner, Steffen Meyer and Andreas Hackethal; Social Science Research Network, August 2, 2012.