One of the longest-standing puzzles in finance is a simple one: why is there so much trading?
Of course, some happens for innocuous reasons; an investor getting new cash has to buy, and a fund seeing outflows has to sell. But this explains only a fraction of actual trading. According to the London Stock Exchange, £72.5bn of FTSE 100 shares changed hands on its members’ orderbooks in September, implying that the average FTSE 100 stock – which should be the core of an equity portfolio – is held for just over two years.
Most trades instead occur because investors disagree – hence the old saying, “it takes differences of opinion to make a market”. Which raises a problem for conventional economics: if investors are rational and well-informed as conventional economics assumes, how can they disagree?
Some economists question the assumption. They say some investors are just 'noise traders' who trade on stale news or none at all, so we get trade as these buy and sell to and from informed investors.
This explanation, however, runs into a problem. It implies that the informed investors should systematically beat the market as they trade with mugs. But very few people do this. The FCA has found that actively managed funds “did not outperform their own benchmarks after fees”. And City University’s David Blake says the “vast majority of fund managers” are “genuinely unskilled".
What we need, then, are explanations of why reasonable people disagree so they trade without either side of the trade systematically winning or losing, so trade occurs without some group beating the market over the long run.
Here, though, we run into another problem. One of the most plausible reasons for such disagreement predicts not that there’ll be plenty of trading but that there’ll be none. The Nobel laureate Daniel Kahneman has shown that we value things more highly merely because we own them: he calls this the endowment effect. But if owners value an asset more than non-owners, they’ll not agree a price and so no trade will happen. This is exactly what happens in the housing market. So why doesn’t it happen in the stock market much?
Certainly, there are many reasons why we’ll have different portfolios. For example, lots of research shows that people who saw bad times in their formative years hold fewer equities later in life than those who saw better times, and the equities they do hold are more likely to be value stocks than growth ones.
This alone, however, only explains one-off trades. It doesn’t explain heavy everyday trading.
So what does? One thing, said Princeton’s Harrison Hong and Harvard’s Jeremy Stein in a classic paper, is simply different prior beliefs. Imagine a company announces a 10 per cent rise in earnings. If you were optimistic about the company's prospect before, you might well buy on this news. But somebody expecting a bigger rise might instead sell. So we’ll get trading.
But there’s something else. We update our priors differently. The idea that increasing information will eventually cause us to agree upon the truth – and so stop trading – is thus wrong. Some recent experiments by Samuel Hartzmark, Samuel Hirshman and Alex Imas, three US-based economists, have shown how. They gave some people different mobile phone chargers and then showed them Amazon ratings for them. They found that those who were given the chargers reacted more strongly to both good and bad ratings than people who weren’t given them. “Individuals appear to overreact to information about goods that they own compared to goods that they do not, with owners being more likely to over-extrapolate from recent signals,” they conclude.
The same thing, they say, happens in stock markets: share owners react more strongly to news than non-owners do. This can generate trade. If you own a share and see it faltering, you’ll be tempted to sell (especially if you are sitting on a profit) while a non-owner being less swayed by such news, might be willing to buy.
This is a special instance of a wider phenomenon – of what Cass Sunstein and Ed Glaeser, two Harvard professors, call asymmetric Bayesianism. We interpret news as reinforcing our prior beliefs, with the result that the same new information leads to greater polarisation. An obvious example of this is Brexit: an issue that most of us didn’t care much about a few years ago now divides the country. The same thing happens with equity investors: the same news – which is often ambiguous anyway – can make bears more bearish and bulls more bullish. And more disagreement means more trades.
Four things reinforce this habit. One is wishful thinking; we want to believe we were right and the wish is father to the belief. Related to this is ego involvement; we hate admitting we were wrong, even to ourselves and so find ways of persuading ourselves we were right. A third is overconfidence; we overestimate our intellectual skills and so think we can better interpret news than the guy on the other side of the trade. Bard Barber and Terrance Odean, two California-based economists, have shown that this explains why many people trade too much and lose money.
On top of all this there is what the University of Haifa’s David Navon calls egocentric framing. We pay too much attention to our own ideas and fail to ask: if I’m so sure this stock is worth buying why is its owner so keen to sell it? The failure to ask this question explains, for example, why investors have consistently paid over the odds for newly floated shares.
What’s at issue here is, of course, not merely an academic question. It should colour everything we do. We should ask ourselves before every trade we do: why do I know more than the person on the other side of this trade? After all, you cannot both be right.