Financial Decision Making

Understanding Chinese Investment Behavior

Ning Zhu

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781317215189
• Edition: 1
• Topic: Economia
• Subtopic: Teoria economica

This book sheds light on financial decision making and lays down the major biases in human behavioral decision making, such as over-confidence, naive extrapolation, attention, and risk aversion, and how they lead investors and corporations to make considerable mistakes in investment.

It draws on a large body of literature, from psychology and social psychology to, most importantly, behavioral economics and behavioral finance. It also looks at the progress in behavioral finance research over recent decades and includes research outputs based on retail and institutional investors from the United States, China, and many other international financial markets.

The book focuses on China's financial reforms and economic transition and includes many cases from that country to highlight the importance of behavioral finance and investor education. It therefore provides much needed in-depth understanding of the Chinese capital market.

1
Disappointing Performance

Invest to lose

On January 24, 2008, Société Générale, the largest financial institution in France, announced that the company had lost 4.9 billion euros (equivalent to 7.2 billion US dollars at the time), due to the fraudulent transactions of one of its employees. The news sent the company’s share price plunging and its bonds were downgraded by most leading rating agencies. Thereafter, more details started to emerge as to what had caused such a large and prestigious financial institution to lose such a large sum of money so suddenly.

The rogue trader, Jérôme Kerviel, was a fairly junior employee in Société Générale’s futures trading department. With his working experience in compliance, he managed to make up fraudulent trades to circumvent the bank’s internal control and risk management rules and placed a huge number of unwarranted bets on Eurex index futures. At the peak of his speculation, the position that Société Générale held was 777 billion US dollars—much larger than the market capitalization of 526 billion in the same period.

Trading losses of this scale may be hard to believe, but they are far from rare. Dozens of trading scandals have resulted in companies losing billions of dollars. For instance, the US investment bank Morgan Stanley lost 8.6 billion dollars from its credit default swap (CDS) trading during the 2008 global financial crisis, setting the record for the largest single trading loss in the past decade. In addition, the US commodities trading company Amaranth Advisor lost 6.5 billion dollars from its bets on energy prices, which not only rocked the energy trading market but also cost the company its life.

A decade earlier, in September 1998, the once-lustrous hedge fund Long Term Capital Management, which was founded by some of Wall Street’s star traders and several Nobel Prize-winning economists, lost over 5.8 billion dollars. These losses were so big and so devastating to the global financial system that the US Federal Reserve had to coordinate all of the leading investment banks to bail out the fund. Meanwhile, in Asia, the Japanese trading conglomerate Morimoto lost 3.4 billion dollars in its copper trading.¹

The list goes on and on, and investors are often shocked that such specialized and supposedly sophisticated financial institutions can lose so much money. However, many investors—and especially retail investors—fail to realize how much they lose from their own trading, too. According to studies carried out between 1995 and 1999 in the Taiwan stock market, Taiwanese retail investors lost an average of 3.8 percent in their trading. That equates to a total loss of 940 billion New Taiwanese dollars, or about 34 billion US dollars, over those five years. Put differently, Taiwan’s investors lost about 6.5 billion US dollars every year in the second half of the 1990s—not too different from the large losses that some financial institutions have suffered. Unlike the institutions, though, the retail investors’ losses seem to be persistent and continuous. They continued to lose money every year, and suffered particularly large losses in the Southeast Asian financial crisis of 2007 and 2008.²

Such trading losses are quite sizable, given the scale of the Taiwanese economy as a whole. For instance, 6.5 billion dollars represents 2.2 percent of Taiwanese GDP, 33 percent of private consumption in transportation and media, 85 percent of household expenditure on apparel, and 170 percent of household expenditure on fuel and energy.

In contrast to the institutional investors’ losses, which are difficult to trace to a single common source, retail investors’ trading losses can be grouped into three major areas:

• 34 percent were due to government taxes, levies, and fees;
• 27 percent were due to commissions collected by brokerage firms; and
• 27 percent were due to investors’ misguided stock picking decisions.

The remaining 12 percent were due to poor market timing decisions.

Aside from the fees and levies that retail investors paid to the government and brokerage firms, about one-third of all retail investors’ losses were transferred to trading gains to their trading counterparties, namely institutions. To be more specific, retail investors’ trading losses make up about 1.5 percent of the investment profits garnered by Taiwanese financial institutions. To some extent, then, retail investors—who normally earn far less than finance professionals—are providing generous charitable donations to investment professionals.

Such comprehensive trading records are available in only a limited number of countries, but it is still possible to discern the same pattern around the world: retail investors generally lose money, or at least perform worse than the market index. For example, Chinese retail investors’ under-performance is worse than that of institutional/professional investors, and the Chinese A-shares market is close to ten times that of the Taiwanese market in terms of trading volume. Therefore, it is quite likely to assume that Chinese retail investors lose ten times more than Taiwanese investors as a result of their trading activities.

The performance of retail investors

When asked about their investment performance, many retail investors do not really have a clear idea. Many of them will be able to remember a particular stock they bought recently and maybe that stock’s performance. But they rarely know the performance of their whole portfolio. In some extreme cases, they will not even know which stocks they hold or the prices they paid for them.

Partly because retail investors do not see their investment performance in the context of their whole portfolios, and partly because they are not familiar with their investment performance, many of them are unjustifiably aggressive in their investment activity. As a result, their performance is generally lower than their respective market benchmarks.

In addition, retail investors have to pay large proportions of their investment proceeds to government and brokerage companies in the form of taxes, levies, and commissions. Furthermore, because retail investors do not have the same level of investment acumen and sophistication as professional investors, they generally lose some of their wealth to more sophisticated investors—without even realizing that they are suffering from a disadvantage.

If we were to form a huge investment portfolio by pooling the portfolios of all the world’s retail investors, we could mimic their trading decisions by buying exactly the same number of the same stocks at the same time—and selling exactly the same number of the same stocks at the same time—as each retail investor makes a trade. The performance of such a portfolio would therefore reflect the performance of all retail investors. Based on such a methodology, researchers have found that US retail investors in the 1990s and Chinese retail investors in the 2000s both significantly under-performed the market index.³

Another way to evaluate the performance of retail investors is to assess their performance when they switch their holdings from one stock to another. Obviously, when an investor decides to sell one stock and buy another, she believes that the new stock will outperform the old stock. After all, every investor trades in order to make money, or to make more money. However, ten years of data from one large discount brokerage firm and a large retail brokerage firm in the U.S., and eight years of data from another large discount brokerage firm in China, reveal quite the opposite. The stocks that investors bought after selling their original portfolio holdings under-performed their original stock picks by a wide margin— 3.5 percent per year. Surprisingly, then, retail investors tend to lose money when they trade, rather than make money.⁴

There is yet another way to assess retail investors’ success, which is to track their buy-and-hold performance. With retail investors who hold their portfolios for a long time, we can simply compare their long-term performance with a market benchmark. According to research in the US and China, no more than 10 percent of retail investors out-perform the benchmark. Of the others, about half perform about the same as the benchmark, while the remainder considerably under-perform the market index.⁵

Moreover, the net returns that retail investors are able to reap net of transaction costs (commissions, levies, stamps, and tariffs, and the price impact resulting from transactions) are considerably lower than their gross returns before transactional costs. Unfortunately, many retail investors believe that the more they trade, the more likely they will be able to make money. If such a logic were true, highly active retail traders would tend to reap high returns, and vice versa. However, researchers have found a strong and significant negative relationship between a retail investor’s turnover (their total trading volume divided by the average size of their portfolio in a calendar year) and their net investment returns. That is, the more a retail investor trades, the lower their net returns tend to be. This phenomenon suggests that investors do not possess the necessary information to justify their frequent trading. Some of the “information” that prompts an investor to trade will be merely “noise” that does not provide much investment value. In addition, the negative relationship between frequent trading and net return suggests that transaction costs are so high that they erode the already unimpressive gross returns from high-volume trading.⁶

Evidence from the United States, Sweden, Finland, Israel, China, and Korea confirms the aforementioned findings that retail investors around the world all significantly under-perform their respective market benchmarks, both before and especially after transactional costs are taken into account.⁷

Many retail investors are surprised by—and often refuse to accept—such findings. A very common rebuttal is: “This cannot be true because I know for sure that I have made money from investing in the stock market this year.” Investors in emerging markets, such as China, express considerable skepticism when advised to invest through delegated portfolio management channels, such as mutual funds or index funds. They argue that they want to pick their stocks themselves, rather than hand over control of their money to someone they cannot monitor. Others feel that they may be better at picking stocks than picking mutual funds or mutual fund managers, based on the reasoning that timely information on stocks is freely available, whereas information on mutual funds is often hard to find.

This phenomenon is directly related to many investors’ subjective (mis)perception of their investment returns (a topic that we will discuss in greater detail later), but it is also linked to their lack of understanding of basic finance and investment. People tend to be very selective when digesting investment-related information and making investment decisions. On the one hand, many retail investors are under the impression that investment is easy and rewarding. Many of them are able to reel off lists of “friends” who have made fortunes from the stock market. And they generously share details of the good investments they have made and brag about how much money they have made themselves. On the other hand, they selectively forget about the stocks that have caused them to lose money. According to extensive research, investors are often unwilling to liquidate their losing stock picks. Instead, they retain them within their portfolios in the hope that they will at least break even eventually. This pattern of behavior leads many to forget about their losing stocks. And even if they are fully aware of their losses, few choose to discuss such disappointing investments in public. This selective communication of investment performance leads many retail investors to believe that investing is easy, even though most of them continue to under-perform the market index and other benchmarks.⁸ Consequently, retail investors suffer from unjustified confidence in their investment abilities and investment performance, which in turn leads to them trading far more frequently than they should, especially in Asia. As mentioned earlier, the more frequently an investor trades, the worse her investment performance tends to be.

To make matters even worse, most retail investors often fail to realize that, for them to make money from investing in the stock market, they should expect performance that is not only commensurate with but much higher than the market index. Through their own often hasty and casual trades, retail investors can provide big favors to institutional investors, such as mutual funds. So, when mutual funds try to sell stock, they often find willing buyers among the ranks of retail investors. Similarly, when mutual funds wish to buy a particular stock, they often find that retail investors are willing to sell. Because retail investors are less sophisticated than the mutual funds, and because they often use market orders to expedite their transactions, they provide much needed liquidity to the funds, which enables the latter to reduce the impact of their trades and enhance their investment performance. In this regard, retail investors should be rewarded for helping the funds and should achieve investment performance that is significantly higher than the market benchmark. But they do not. As we have seen, retail investors significantly under-perform their respective market benchmarks in almost every stock market around the world.⁹

Many retail investors also neglect to include transaction costs in their calculations of their own performance. All retail investors have to pay (sometimes exorbitant) fees and taxes when trading stocks. Such fees and taxes result in much lower net returns. For example, US retail investors on average paid transaction fees of 0.7–0.8 percent of their principals during the 1990s. Transaction fees have dropped to 0.2–0.3 percent due to the introduction of online trading and discount brokerage services, but the cost is still significant if one takes into consideration that the average US retail investor will turn over her portfolio approximately 100 percent every year.

A similar pattern prevails in China. Even though Chinese investors on average face relatively low transaction costs of about 0.2–0.3 percent, they turn over their portfolios very frequently. With an average annual turnover rate of over 400 percent, transaction costs can easily eat away at any retail investor’s gross returns, setting them back even further.¹⁰

In addition, retail investors normally use cash as a benchmark to evaluate their performance. Put differently, they tend to think of their gains and losses in the context of whether they have made money or lost money, yet ignore their investment opportunity cost, which is the performance of the market benchmark. For instance, if the market has risen by 10 percent in a year, and the investor has achieved a 5 percent of return on his own investment, he should realize that his ...

Table of contents

• Cover
• Title
• Copyright
• CONTENTS
• Foreword
• 1 Disappointing performance
• 2 Unsettled investors
• 3 Under-diversified portfolios
• 4 Mistimed timing and misguided stock picking
• 5 Disappointing mutual fund performance
• 6 Irrational mind
• 7 Behavioral biases and investment decision making
• 8 Difficult history
• 9 Learning by investing
• 10 Over-confident CEOs
• 11 Catering CEOs
• 12 Risk management! Risk management!
• 13 Regulation and government decision making: the behavioral biases of governments and regulators
• 14 How to reform
• Index