VANCOUVER, British Columbia — Looking to take a stab at the stock markets, but aren’t sure where to begin? Try not to put too much stock in deciding what to buy. An interesting new study finds that novice investors are actually better off choosing stocks completely at random instead of making their own decisions.
Thanks to the emergence of free, easy to use stock trading platforms, more consumers than ever before are trying their hand in the stock market. These platforms allow users to avoid high financial management fees, all while controlling their own stock portfolio. While these developments have certainly made it easier for the average person to start trading stocks, the study, conducted at the University of British Columbia, finds that many of these less-experienced investors are failing to diversify and could be putting themselves at great financial risk.
For the study, researchers asked study participants to create investment portfolios using tables of previous financial asset returns, then assessed their level of financial literacy. The research team found that investors with poor financial literacy usually chose positively correlated assets, such as stocks in oil and forestry, that tend to fluctuate in value together.
“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,” explains study co-author David Hardisty in a media release. “But 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.”
More experienced investors in the study, on the other hand, hedged their bets by always including negatively correlated, or uncorrelated, assets. Negatively correlated assets move up while the other moves down, and uncorrelated assets move up and down independently of each other. This more experienced approach to stock investing is a much better strategy to protect against potential financial losses.
Hardisty and his team also found that the average amateur investor preferred correlated assets because they seemed less complicated and more predictable.
“If it seems predictable, it seems safer and easier to track,” comments Hardisty. “Whereas if you have a combination of assets that all go in different directions, it seems chaotic, unpredictable and riskier.”
Rather ironically, novice investors actually made safer, more diversified decisions when they were encouraged to make riskier choices by researchers.
“This shows that amateur investors rely on a definition of risk that greatly differs from the objective definition of portfolio risk,” says Yann Cornil, another co-author on the study. “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.”
On the bright side, researchers say that the less experienced investors were able to see and acknowledge the errors in their approach after being encouraged to view their portfolios as a whole, instead of just focusing on each asset separately.
The study’s authors encourage everyone thinking about dabbling in the stock market to do the proper amount of research before diving in, and to always take advantage of the diversification tools and education opportunities that many platforms offer to new investors.
The study is published in the journal Organizational Behavior and Human Decision Processes.