Many Investors Can Beat the Market

“At first glance, it would seem that a search for evidence that individual traders outperform the market is not very promising,” said Tyler Shumway, associate professor of finance at the U-M Business School. “Individual traders are often regarded as, at best, uninformed, at worst, fools. However, not all individual traders do poorly in their investments.”

Shumway and colleagues Joshua Coval of the Harvard Business School and David Hirshleifer of Ohio State University examined nearly 17,000 individual accounts at a national discount brokerage firm in which investors bought at least 25 stocks from 1990 to 1996. They found that the top 10 percent of investors earn excess returns of 15 basis points (a basis point is one one-hundredth of a percent) per day in the week following a trade---which equates to an individual trader beating the market by roughly 3 percentage points a month.

Using a series of statistical tests, the researchers found that about 20 percent of individual investors are skilled in picking high-performing stocks---in other words, not just due to luck. On the other hand, they found that traders among the bottom 10 percent of all investors place trades that can expect to lose up to 12 basis points per day during the subsequent week.

The difference in returns for the top traders and those investors who fare poorly diminishes after a one-month holding period. However, savvy investors who employ a strategy of taking a long position on stocks that have performed well to date and shorting stocks that have performed badly can expect excess returns of 5 basis points per day over the entire holding period of the trade, the study shows.

“These returns are not confined to small stocks nor to stocks in which the investors are likely to have inside information,” Shumway said. “Our results suggest that skillful individual investors exploit market inefficiencies to earn abnormal profits, above and beyond any profits available from well-known strategies based upon size, value or momentum.”

Even though a fair number of investors can regularly beat the market, individual traders as a group lose money, on average, the researchers say. However, even some investors who consistently lose money may be able to learn how to make abnormal profits by reversing their trading strategies.

“If traders vary widely in terms of their ability to select investments, and if they learn about and develop this ability through trading, it may, in fact, be rational for some investors to trade frequently and at a loss, in the hope of future gains,” Shumway said.

For more information, contact:
Bernie DeGroat
Phone: 734.936.1015 or 734.647.1847
E-mail: bernied@umich.edu

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