Unfortunately, a number of people make common investment mistakes that may create barriers to reaching financial goals. A Library of Congress report on investor behavior discusses the three common investment mistakes: Disposition Effect, Noise Trading, and Naïve Diversification. Following is some information about these three mistakes.

Disposition Effect

“The disposition effect is the tendency of investors to sell winning positions and to hold onto losing positions.”1 In a study of the disposition effect, Terrance Odean, of the University of California Finance Department, asks the question: “Are Investors Reluctant to Realize Their Losses?”1, 4 He answered yes. He stated the disposition effect is “counterproductive” and “widely operative”.1

“According to Odean’s study, in the months following the sale of winning investments, these investments continued to outperform the losing ones still held in the investment portfolio, an outcome exactly the opposite of that intended. Loss-averse investors sell high performing investments hoping to recoup their losses on poor performers but, in fact, achieve the reverse. In “Myopic Loss Aversion and the Equity Risk Premium,” Shlomo Benartzi and Richard H. Thaler, business school professors at the University of California Los Angeles and the University of Chicago, respectively, coin the term “myopic loss aversion” to describe the tendency of loss-averse investors—even if long-term investors—to evaluate their portfolios frequently.1 The authors consider the long-term investors’ focus on short-term results an unfortunate form of myopia applied to investing.” 1

Naïve Diversification

Do you participate in a Defined Contribution Saving Plan? The Naïve Diversification mistake applies to how investors allocate their assets in the plan. In other words, if you are given n options, you allocate your assets proportionally among them, so that each receives 1/n of the total.1 Shlomo Benartzi and Richard H. Thaler mention that naïve diversification is not always a bad thing for unsophisticated investors, but may prove costly if the employer provides a poor selection of choices. The study implies that employers should design retirement plans carefully, to produce a scenario in which naïve diversification becomes an effective strategy.1, 2

Noise Trading

“As a technical term, ‘noise’ refers to false signals and short-term volatility that obscure the overall trend. Therefore, ‘noise trading’ describes the activities of an investor who makes decisions regarding buy and sell trades without the use of fundamental data. These investors generally have poor timing, follow trends, and overreact to good and bad news.”3, 1

In “All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Brad M. Barber and Terrance Odean show that although individual investors are net buyers of attention-grabbing stocks—stocks that are in the news or that experience abnormal one-day returns or trading volumes—these stocks subsequently do not perform as well as the stocks that the same investors decided to sell.4 This research suggests that day trading is not a worthwhile activity.”1

We hope you have enjoyed this little series.  Make sure you check out our other two posts of Common Investment Mistakes.

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  • http://www.sec.gov/investor/locinvestorbehaviorreport.pdf
  • Shlomo Benartzi and Richard H. Thaler, “Naive Diversification Strategies in Defined Contribution Saving Plans,” American Economic Review 91, no. 1 (March 2001): 79–98. Available by subscription from JSTOR, http://www.jstor.org/stable/2677899 (accessed December 10, 2009). Also available from http://faculty.chicagobooth.edu/richard.thaler/research/pdf/ (accessed January 15, 2010)
  • “Noise Trader,” Investopedia, http://www.investopedia.com/terms/n/noisetrader.asp (accessed June 18, 2010)
  • Brad M. Barber and Terrance Odean, “All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors,” Review of Financial Studies 21, no. 2 (April 2008): 785–818. Available by subscription from Oxford Journals, http://rfs.oxfordjournals.org/cgi/reprint/21/2/785 (accessed January 5, 2010). Also available from http://faculty.haas.berkeley.edu/odean/papers/Attention/All%20that%20Glitters.pdf (accessed January 16, 2010).