Investing and the Internet
The Internet (Psycho) Investor
The Rise of the Internet Investor Amplifying Psychological Biases Advertising - Increasing the Biases Online Trading and Performance Day Traders - The Extreme Case Summing Up t is hard to believe that the World Wide Web first began to be mentioned in the news media in 1993 and that the first Web browser became available to the public in 1994. Yet, by the year 2000, there were over 100 million Americans browsing the Internet. 1 he Web s unprecedented growth in users is paralleled by its effect on the general economy. Companies like America Online (AOL) and Amazon.com did not exist in 1990; by 2000 they were two of the largest firms in the country. The value of all Internet firms was only $50 billion in 1997, growing to $1.3 trillion in 2000.
The growth of the Internet has changed the way people communicate with each other, shop, conduct business, and receive news and information, and that's just the tip of the iceberg. The Web is also changing the investment landscape.
THE RISE OF THE INTERNET INVESTOR
The Internet has given investors many new advantages. The online investor enjoys lower commissions, greater ease of access, and higher speed of trade executions. No wonder there were 20 million online accounts at the end of 2000. Even investors who don't actually trade online can enjoy increased access to information.
Three different types of companies are providing information on the Web. First, companies that were not originally focused on the finance industry (like Microsoft and Yahoo!) developed investment information services. Second, firms that distributed financial information through traditional distribution channels (like Morningstar and Value Line) began Internet operations. Finally, new investment Internet firms (like Motley Fool and Silicon Investor) were created.Investment information is also available from the online brokerage firms. Indeed, the ease of access to this information has been a major part of their advertising campaigns. Popular online brokerage firms like E*TRADE and Ameritrade only just started on the Internet in the 1990s, while others (like Schwab Online) were created by traditional brokerage houses.
Many investors like the new tools provided by these Internet firms and Web services. The speed and ease of using online brokers combined with a powerful bull market made making money by investing appear easy. In fact, by the end of 1999 there were an estimated 5,000 investors actually trading as a full-time job. These investors were dubbed day traders. The phrase itself implies that these people are not investing for long-term goals.
AMPLIFYING PSYCHOLOGICAL BIASES
Traditional economics hails the investment advantages created by the Internet as beneficial to you - lower commissions, greater speed and ease of trading, and increased information flow all work to reduce market frictions. A reduction in market frictions improves the marketplace. However, these same attributes magnify your psychological biases. The benefits of the Internet are offset by the harm done to you if you are affected by these biases. Psychological biases that are particularly exacerbated by the Internet are the illusion of knowledge and the illusion of control, which lead to overconfidence. Additionally, in Part 2 of this book, emotional factors such as pride, regret, the house money effect, and get-evenitis are magnified.
Information and Control
Using the Internet, you have access to vast quantities of information. This information includes historical data like past prices, returns, and corporate operating performance, as well as current information like real-time news, prices, and volume. Your information access on the Internet is nearly as good as that of professional investors. However, since you probably lack the training and experience of professional investors, you are therefore less sure how to interpret the information - the information does not give you as much knowledge about the situation as you might think.
Many individual investors recognize their limited ability when it comes to interpreting investment information, so they further use the Internet to help them. They get analysts' recommendations, subscribe to expert services, join newsgroups, and learn the opinions of others through chat rooms and Web postings. However, investors must be discriminating when it comes to picking and choosing from this plethora of information. For example, you need to take what you see in these chat rooms with a grain of salt. Not all recommendations are from experts - in fact, most chat postings are from Joe Blow down the street. A recent study examines the stocks recommended in messages posted on two Internet newsgroups.2 The performance of most of the stocks recommended on the message boards had been very extreme - big gains or losses. The stocks with very good performance the previous month were recommended as a purchase (momentum strategy). These stocks subsequently underperformed the market by 9% over the next month! The stocks that were recommended for purchase with extreme poor performance during the previous month (value strategy) outperformed the market by nearly 9% over the following month. Overall, the stocks recommended for purchase did not perform in a way that was significantly different than the market in general. So, you can see that these recommendations do not contain valuable information. However, if you perceive the messages as having increased your knowledge, you may be overconfident about your investment decisions.
The Internet fosters active involvement by providing the medium for investment chat rooms, message boards, and newsgroups. Internet investment services firms like Yahoo!, Motley Fool, Silicon Investor, and the Raging Bull sponsor message boards on their Web sites for investors to communicate with each other. Yahoo! had message boards for over 8,000 companies in 1998. Users post a message about a company using an alias or simply read the message postings of others.
Consider the messages posted on Yahoo! between December 1, 1997, and July 1,1998, for 3,478 companies.3 The average number of postings for these firms was 272. Almost 100 companies had postings in excess of 10,000 total messages. The number of postings on a firm's message board helps to predict the trading volume of the stock the following day. Higher levels of overnight message postings are associated with a higher trading volume the next day. Clearly, many online investors are actively participating in the process, exchanging information, ideas, and opinions in the formation of their trading decisions.
Online Trading and Over confidence
The illusion of knowledge and the illusion of control are attributes that lead to overconfidence. Chapters 2 and 3 describe overconfi-dence in detail and show how overconfident investors trade too much and subsequently earn a lower return. If the Internet truly exacerbates the psychological biases that cause overconfidence, it follows then that online investors should trade too much and experience decreased returns. Indeed, it appears that this is the case. For an example of this, lets look at the trading behavior of 1,607 investors who switched from a phone-based trading system to an Internet-based trading system at a discount brokerage firm.4
I have already mentioned that portfolio turnover is a measure of how much an investor trades during the year. If you own 10 stocks and sell 5 of them to purchase new stocks during the year, you have a 50% turnover. The higher the turnover, the greater the amount of trading. In the two years prior to our 1,607 investors going online, the average portfolio turnover was about 70%. After going online, the trading of these investors immediately jumped to a turnover of 120%. While some of this increase is transitory, the turnover of these investors is still 90% two years after going online (see Figure 12.1).
PORTFOLIO TURNOVER BEFORE AND AFTER ONUNE TRADING. |
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Figure 12.1 |
Before Going Online After Going Online |
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■ Total Turnover ^^_ O Speculative Turnover |
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5/o 20% 40% 60% 80% 100% Annualized Turnover |
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However, some of this increased trading, instead of being caused by overconfidence, may result from investors trading to take advantage of liquidity needs or tax-loss selling (see Chapter 5). To investigate trading likely due to overconfidence, the study examines the sales of stocks that resulted in capital gains that are then followed by a stock purchase within three weeks. For example, say you own shares of Cisco and that the stock has doubled in price. If you sell Cisco to buy Intel, you have not traded to change your asset allocation, nor to obtain cash for spending. Instead, you have traded one stock for another. These trades are considered speculative trades. Speculative turnover was 16% two years before going online, and it nearly doubled to 30% two years after going online.
Investors are also turning retirement investments into trading capital. Some firms have given their employees the capability to trade their 401(k) plan assets online. How do the employees/ investors react? They trade. One study investigates the effect of web-based trading in 401(k) pension plans.5 The advantage of studying these trades is that, since they occur within a qualified pension plan, liquidity needs and tax-loss selling are not factors and thus all trades can be considered speculative. In two companies studied, 100,000 plan participants were given the opportunity to trade their 401(k) assets using an Internet service. The study finds that, after the companies switched to the online service, trading frequency doubled and portfolio turnover increased by 50%.
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