Why amateur investors are better off picking stocks at random
Whether it’s a desire to save on management fees or the thrill of picking winning stocks, a growing number of investors are going at it alone.
User-friendly online trading platforms mean it has never been easier to research and select stocks for a portfolio. That doesn’t mean you should try to channel your inner Warren Buffett, because a new study from the UBC Sauder School of Business finds amateur investors are actually better off choosing stocks at random.
The study found investors with the least financial literacy tend to choose positively correlated assets, like oil and forestry stocks, which often move in tandem.
“An amateur investor might buy stocks in lumber, mining, oil and banks, and believe they are diversifying because they’re investing in different companies and sectors,” David Hardisty, assistant professor at UBC Sauder and co-author of the study, said in the report.
“Because all of those equities tend to move in unison, it can be quite risky, because all the assets can potentially plunge at the same time.”
Seasoned investors know to hedge their bets by diversifying, even if that puts a ceiling on potential returns. It’s a prudent move to mitigate the risk associated with a concentrated portfolio.
“In the best-case scenario, you could make lots of money and have an extra vacation, or buy a car or something like that,” said Hardisty.
“If your whole portfolio crashes, you could risk losing your life savings. So, the best-case scenario isn’t that much better, but the worst-case scenario is a whole lot worse.”
The study found aiming for simplicity, rather than higher returns, is what gives rookies tunnel vision.
“If it seems predictable, it seems safer and easier to track,” said Hardisty.
“Whereas if you have a combination of assets that all go in different directions, it seems chaotic, unpredictable and riskier.”
When investors were encouraged to take on more risk, they did the opposite and diversified.
“This shows that amateur investors rely on a definition of risk that greatly differs from the objective definition of portfolio risk,” Yann Cornil, assistant professor at UBC Sauder and co-author of the study, said in the report.
“This can lead them to make objectively low-risk investments when they intend to take risk, or to make high-risk investments when they intend to reduce risk.”
Amateur investors saw the light once they were shown the aggregate returns of portfolios, instead of individual assets.
Jessy Bains is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jessysbains
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