Chapter 28 Individual Investor Trading

Individual investors trade stocks in a way very different from what mainstream financial economic theory would predict: they generate too much trading volume and yet obtain belowbenchmark performance. This chapter overviews major 'puzzles' of individual investor trading. The extant literature suggests that behavioral biases and psychological explanations are largely responsible for many of the observed patterns in individual trading. The chapter discusses three aspects of individual investor trading, namely the disposition effect, the local bias, and the ability to learn over trading, followed by a discussion of the costs associated with individual investor trading. INTRODUCTION The extraordinarily high degree of trading in financial markets represents major challenges to the field of finance. The New York Stock Exchange (NYSE) website indicates that the annual share turnover rate in the early 2000s on the NYSE was close to 100 percent, amounting to a total volume of about 350 billion shares per year. Using reasonable estimates of per-trade costs, this implies that the investing public voluntarily pays several billion dollars to financial intermediaries every year. International markets, especially many stock markets in Asia, witness even higher turnovers (Barber, Lee, Liu, and Odean, 2009, Feng and Seasholes, 2004) and trading costs. Such stylized facts are in stark contrast with many theoretical models in finance such as those found in Aumann (1976) and Milgrom and Stokey (1982), which argue that there should be no trading at all.