The Influence of Perception on the Urge to Trade

Consider this scenario: You are presented with two market environments. In the first, the S&P 500 has risen nearly 10% and is holding onto its gain heading into what should be a good earnings season. In the second, the S&P 500 has not only pulled back, but also closed below its 50-day moving average for the first time in six months. Which market environment would you prefer to invest in?

If the first one sounds more enticing, or at least more comforting, than the second one, you’re not alone. We humans do not like losing money, much less incurring an identifiable risk of losing money. But what’s more interesting is that the two scenarios both accurately describe the S&P 500 as of yesterday’s close. The only difference is how they are framed; how they describe the current market environment.

Since last November’s elections, the S&P 500 has gained 9.6%. The rally has stalled as of late, however, with the large-cap index sitting 2.2% below its record closing high. This modest decline led to the S&P 500 closing below its 50-day moving average for the first time since Election Day. The breach, however, occurred at a higher level—as the index rose to higher levels, so did its moving averages. (Moving average lines trace the average price of an index, fund or security; think of them as a series of connected dots, with each dot shifting the calendar period used to calculate the average forward by one day.) As far earnings season is concerned, Thomson Reuters says favorable year-over-year comparisons for the energy sector could lead to the strongest growth in first-quarter revenues and earnings in over five years.

We often see framing used in the description of how the markets are performing on a given day. Relatively common declines on a percentage-point basis, say 0.5%, are described with words implying a significant drop. (I’ve noticed that the headline writers at Yahoo Finance are particularly guilty of this.) Yet when one takes a step back and considers both market history and the actual magnitude of the change, the market’s daily fluctuation is often nothing more than a case of “nothing to see here, move along.” Of course such descriptions do not grab attention or generate clicks, but that’s a discussion for a different day….

Among the problems with framing is its tendency to lead to excess trading. Investors, both individual and institutional, get lured into short-term thinking by focusing too much on the here and now as opposed to the long term. Such tendencies make it difficult to cope with short-term volatility. A study by a Norwegian business professor found that investors, in aggregate, held stocks for just 0.75 years. Put another way, half of all investors hold stocks for nine months or less.

For those of you who are curious, individual investors held onto their stocks the longest, with a median time horizon of 0.833 years (10 months). Financial investors (e.g., mutual funds) had the shortest time horizons, with a median time horizon of just 0.499 years (six months).

This study analyzed the holding periods of Norwegian stocks listed and traded on the Oslo Stock Exchange (OSE) between 1997 and 2007. There are relatively few studies of this type because of the difficulty in obtaining the necessary data. The OSE has a registry listing all trades, including sector codes identifying the type of investors. While there may be differences between Norwegian investors and American investors, the tendency of investors to trade more frequently than they should is an international phenomenon. For example, a study by Terrance Odean and Brad Barber about Taiwanese traders and overconfidence has been widely cited here in the U.S. For those of you who prefer data on Americans, analysis of mutual fund returns conducted separately by Morningstar and research firm Dalbar shows investors underperforming the very funds they invest in.

When we allow short-term events to influence our judgment, it shifts our attention away from the strategy of reaching our long-term goals. This is why I think there is an advantage to trading slower, not faster. Purposely stopping yourself before making any change to your portfolio may give you the mental and emotional break necessary to reassess the situation and consider whether or not the action truly is beneficial from a long-term standpoint.