Week 5 - Individual investors

Question 1

Why do we study investor behaviour?

Answer 1

• Individuals are required to invest: worldwide trend toward defined contribution retirement savings plans.
• It is easy to invest: the costs of entering the stock market have fallen and the number of individuals investing in equities has increased.
• Active investing is a zero-sum game:
  -Many individuals seem to have a desire to trade actively coupled with low security selection ability.
  -With some notable exceptions, the evidence indicates that individual investors are subpar investors.

Question 2

What are the two parts of the retired savings (pension) system?

Answer 2

• Defined benefit (DB) pension systems:
  -Retirement benefit based on the number of working years and salary.
  -The employer or pension plan managers invest the savings.
  -The employer bears the risk of underfunding in case of poor performance.
• Defined contribution (DC) pension systems:
  -Fixed contribution payments.
  -Individual participants usually invest their savings (U.S. - 401k plans). - Sometimes collective DC systems.
  -Individual account: transparency and portability.

Question 3

What are the conclusions for this lecture?

Answer 3

1. Direct holdings of individual investors:
   Investors trade frequently and have poor stock selection ability.
   Investors fail to diversify properly.
   The disposition effect generates unnecessary tax liabilities.
   Investors buy attention grabbing stocks.
2. Allocation of individual investors to mutual funds:
   Investors fail to identify mismatched benchmarks and cannot monitor mutual funds performance successfully.
   Investors direct flows to previously best performing funds, despite little return persistence, causing some stocks to be misvalued.