Is individual investing truly a tale of woeful mistakes and biases? In their March 2012 paper entitled “No Skill, Mere Luck? – An Analysis of Individual Investors’ Investment Performance”, Andreas Hackethal, Steffen Meyer, Dennis Schmoltzi and Christian Stammschulte apply bootstrapping simulations based on actual portfolios to distinguish skill from luck among a sample of individual German investors. They use a four-factor model (market, size, book-to-market and momentum) to estimate risk-adjusted performance (alpha). Using weekly gross and net portfolio returns for 8,621 retail investors employing a German online broker during September 2005 through April 2010 (242 weeks), they find that:
- The sampled portfolios are equity-intensive (58% in stocks and 36% in funds) and home-biased (70% of equities are German), supporting use of German equity market risk factors in assessing alpha.
- On average, the sampled investors give little attention to size, value (book-to-market) or momentum factors in forming portfolios.
- An equally weighted combination of individual portfolios generates a gross (net) annualized alpha of -4.9% (-5.8%), but statistical significance is weak (marginal). Results imply annual aggregate portfolio-level trading friction of 0.9%.
- Results from 1,000 bootstrapping simulations indicate significantly negative skill:
- 89% (91%) of individual investors exhibit negative gross (net) alpha.
- An individual investor of typical risk tolerance exhibits an average annualized risk-adjusted gross (net) performance of -7.5% (-8.5%).
- Individual investors are relatively less skillful during and since the financial crisis than before (break point at end of 2007).
In summary, evidence indicates that individual investors on average significantly underperform the market.
Cautions regarding findings include:
- Sampled investors may not be representative of all individual investors.
- While encompassing both bull and bear financial market states, the sample period may not be representative of long-term investor experience.
- As noted by the authors, while small, investor non-equity holdings do not fit the alpha estimation model.
