Familiarity Breeds Short-Termism

Summary

• Familiarity has been shown to breed investment, as investors confuse familiarity with safety.
• Research shows that familiarity (trading in stock previously had traded) also breeds short-termism, higher turnover.
• Investors tend to lose wealth with their repeated trades; familiarity is costly.

Familiarity has been shown to breed investment, as investors confuse familiarity with safety. Home country bias, in which investors all over the world overweight their home country by wide margins, is a good example of this phenomenon. Ellapulli Vasudevan contributes to the literature on familiarity and its impact on individual investor behavior and returns with his October 2019 study "Familiarity Breeds Short-Termism." He analyzed a large dataset covering almost 20 years (April 1995 to December 2014) of individual investors' trades from Finland, covering 308,000 accounts, to determine if familiarity with a stock influenced investor behavior and if that familiarity led to improved performance. Following is a summary of his findings:

• Investors exhibit a robust and systematic pattern of shortening their holding period in a stock on which they execute multiple round-trip trades.
• On average, the holding period shortens by 11 percent with each additional round trip - the more familiar, the shorter the holding period.
• The tendency to be short-termed is associated with reinforcement learning - investors are more likely to shorten the holding period after a round trip where they could have realized a better return had they sold earlier.
• Investors tend to lose wealth with their repeated trades, earning a four-factor (market beta, size, value and momentum) alpha of -1.3 percent.
• Investors exhibit an increase in the disposition effect (the tendency to sell winning investments prematurely to lock in gains and hold on to losing investments too long in the hope of breaking even) with repeated round trips. The disposition effect doubles by the 15th round trip.
• The propensity to shorten the holding period is more prominent when the round-trip returns are negative than when they are positive. And the propensity to shorten the holding period is monotonically increasing in the magnitude of the missed return opportunity.
• Although price increases after exit are associated with decreases in the propensity to shorten the holding period, the effect is much smaller than it is when returns were negative due to holding longer.

Vasudevan showed that individual investors do not learn from their experiences when trading in the same stock. It appears that familiarity may breed overconfidence, which in turn leads to too much trading, which can be injurious to your financial health. That is what Vasudevan found - the more individuals traded a company's stock, the shorter the holding period became. And short-termism led to negative outcomes. Forewarned is forearmed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.