Self-directed investors might as well pick random stocks says study

UBC finds amateur investors are failing to diversify and misjudge risks

Self-directed investors might as well pick random stocks says study
Steve Randall

While some investors may believe they can manage their own portfolio perfectly well without a financial advisor, a new study questions their abilities.

Amateur investors are failing to diversify according to an analysis from the University of British Columbia’s Sauder School of Business, those investors might as well just pick stocks at random.

The researchers asked participants to pick a portfolio using tables of previous returns but found that those with lower financial literacy tended to pick stocks that generally move 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," said David Hardisty, study co-author and assistant professor at UBC Sauder. "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."

The study notes that experienced investors will hedge their bets with a portfolio of assets that do not move in unison and offset volatility.

But the reason amateurs may pick correlated assets is the perception that they are less complicated and more predictable.

"If it seems predictable, it seems safer and easier to track," explains Hardisty. "Whereas if you have a combination of assets that all go in different directions, it seems chaotic, unpredictable and riskier."

Poor risk perception
The study also discovered that amateur investors are not as in tune with risk as they might think they are.

They found that investors had a different idea of ‘risk’ to the objective definition of portfolio risk and that could lead them to pick safer stocks when encouraged to take greater risks and vice versa.

Hardisty and his co-authors hope that their research will encourage investors to find out more about how investments work rather than relying on innate ideas of balancing risk.

"If you don't diversify, when one asset does well the other ones are also going to do well. But if one does badly it's likely the others will all do badly -- and in investing, you want to avoid those worst-case scenarios," says Hardisty, who hopes the research will encourage investors to educate themselves on investment strategies, and use the diversification tools that online investment services provide to properly balance their portfolios.