According to Stephen Billion, who is defending his thesis on this subject today at Ersasmus University, people may be investing in the stock market not only to maximise their expected return on investment, but also to, consciously or subconsciously, satisfy other human needs. He goes on to say that that deviating from portfolio theory may help satisfy those other needs.
A large body of evidence from finance suggests that individuals are atrocious stock market investors and that this bad behaviour is very costly. For example, one study found that, if an individual sells shares of a company to buy shares of another company, on average, the return over the following year on the shares that he/she purchased will be 3.3 percentage points lower than the return on the shares that were sold. And this is before considering either management fees or commissions on the purchase and sale of the shares.
One mistake that individual investors make is to under-diversify their holdings. A bedrock investment rule is the portfolio theory of investing, which was first formalised by Markowitz (1952). Since that time, variants of portfolio theory have been universally accepted by finance scholars and professionals as the preferred model for stock market investment. The gist of portfolio theory is that investors maximise their risk-adjusted returns by investing in a portfolio of stocks that is diversified by industry and geographically. However, individual investors often under-diversify their holdings much more than portfolio theory suggests is optimal.
Under-diversification can be very expensive. Among other things, under-diversified investors lose because they tend to hold the wrong type of stocks - they prefer stocks that have a small chance of a very large gain (so-called lottery-type stocks), and this type of stock tends to underperform the market. Some groups of investors, however, are more prone to under-diversifying and holding lottery-type stocks than others. For example, single men are more prone to this behavior than married men, who in turn are more prone to it than women.
That this bad stock market behaviour persists in the face of evidence of its cost is perplexing to finance scholars. Given the wealth of information available to investors through the media and professional advisors, it ought to be easy for individual investors to avoid making mistakes such as under-diversifying and holding lottery-type stocks.
Economists assume that individuals invest in the stock market for the same reason that they engage in other forms of savings. They reduce their current consumption and invest the amount of the reduction in the stock market to increase their consumption in the future. But if this were the sole reason, why don’t individual investors invest according to the tenets of portfolio theory?
