Behavioral biases and the trading of individual investors in the Korean stock markets
Previous literature has shown that individual investors in the stock markets trade excessively and underperform the market index. Since the COVID-19 outbreak in 2020, the annual trading turnover of individual investors in the Korean stock markets is estimated as above 1,600% and their investment performance is below the market returns (Kim & Kim, 2021). Their excessive trading and poor performance are not fully explained by rational trading motives (i.e., liquidity needs and portfolio rebalancing) or information asymmetry, but it might be the results of irrational investment decisions originated by behavioral biases.
This report empirically investigates the effect of four well-known behavioral biases; overconfidence, disposition effect, lottery preference, and herding, on the trading behavior and performance of individual investors by utilizing the transaction data of about 200,000 investors in the Korean stock markets from March to October in 2020.
The main results from the empirical analyses are summarized as follows. First, trading turnover of individual investors is positively related to lagged market returns, and the positive relations are more pronounced for the groups of investors who trade more frequently. Also in those groups, post-trade returns of stocks purchased are far less than those of stocks sold. Overall results indicate that investors’ overconfidence induces excessive trading and hinders their investment performance.
Secondly, the disposition effect is clearly confirmed in trading of individual investors, by showing that the probability to sell a stock that has increased in value since bought is higher than that has decreased in value since purchased. In addition, the disposition effect is stronger for investors who lack investment experience and in hard-to-value stocks. Furthermore, the disposition effect is negatively associated with investment performance.
Third, individual investors prefer trading and holding lottery-type stocks more than the institutional investors or foreign investors do. Especially, male and young investors seem to have such strong lottery preference. Lottery preference is significantly related to under-diversification and excessive trading, and the investment performance of whom prefer lottery-type stocks is worse than others.
Lastly, the stock-level proportions of net buying individual investors show a positive serial dependency on both daily and weekly basis, implying the short-term herding behaviors. New or young investors tend to herd more than others and the herding behavior is significantly observed in attention-grabbing stocks, which suggests that individual investors’ herding is closely related to the limited attention bias. In addition, the return reversals after herding imply that the herding behavior is a result of irrational investment decisions.
Overall empirical results show that individual investors in the Korean stock markets are exposed to a variety of behavioral biases and those biases have negative impacts on investment performance. The improvement of trading accessibility and the increase of investment targets and information may exacerbate the negative impacts of behavioral biases for individual investors. In order to mitigate the behavioral biases and their negative effects, the following means need to be considered. First, the utilization of indirect investment vehicles and professional advising services need to be encouraged. If an individual investor realizes a lack of investment expertise, it is desirable to invest in a mutual fund managed by experts or to seek professional advice to reduce the effect of behavioral biases. This presupposed that there is no conflict of interests between the individual investors and the investment firms that provide investment vehicles or advising services. Second, it is necessary to create an trading environment that could reduce the impact of behavioral biases. Individual investors depends too much on the salient information, recent price trends, or buying price. So we can consider improvement for a type or format of information provided to investors, order types, or trading procedure to mitigate behavioral decision making. Third, education programs on financial investment and behavioral biases should be improved. Financial education will not only contribute to the development of investing competency but also help find suitable alternative investment instruments. It is important to develop a education program that can make an actual change in a investment behavior rather than focus on the improvement of financial knowledge.