Learning by Trading

Many studies have shown that individual investors do poorly compared to a buy-and-hold strategy… But part of that is that we don’t start out as savvy traders. We have to climb the learning curve. When you start trading, you don’t know if you are good or bad at it, and you have little idea how to do it well. So through time, as people “pay to learn”, they’ll either figure out that they’re good, or trade less. That’s the pattern found by Seru, Shumway and Stoffman in “Learning By Trading”, and the abstract is worth quoting in full:  

We test whether investors learn from their trading experience. Using a large sample of individual investor records over a nine-year period, we analyze both the disposition effect and trading performance at the individual level. Disposition is costly: the median investor who suffers from the effect earns 3.2% to 5.7% lower annual returns on average than an investor with no disposition.

Disposition falls, and performance improves, as investors become more experienced. An extra year of experience decreases the disposition effect of the median investor by about 4%, which accounts for about 5% of the increase in returns earned by these investors. By controlling for survival and unobserved individual heterogeneity, we show that investors in aggregate learn partly by attrition, but that learning at the individual level is also important. We also find that unsophisticated investors and investors who trade more learn faster, and we show that the trading style of investors changes with experience.

 Here’s an interesting thought about estimates of individual investors’ under-performance – the measurements rely on the percentage of your sample which is naïve versus experienced investors. A more experienced sample would be more bifurcated – there would be two types of investors – those who didn’t trade much (because they learned they weren’t very good), and those who traded more (because they’d learned they were good). A sample of only experienced traders could have quite a good record.

But as long as there is flesh blood coming into the market steadily, they average return record could look quite bad – but depending on experience, the average investor could be quite good.

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