You know all those price tracking alerts you can get from your broker that alert you to changes in price for your favorite stock, mutual fund or ETF, or that alerts you about 52-week highs or lows? They may be prompting you to make significant trading errors and underperform the market. That’s the conclusion of a new study . The authors, Che-Wei Liu, Yanzhen Chen, Ming-Hui Wen, partnered with one of the largest retail mutual fund investment platforms in Taiwan, which provides a free price tracking alerts tool. The database consisted of 20,000 retail investors, consisting of a control group that never utilized the alert features and a group of 932 investors (about 5% of the group) that did. The conclusions of the study: 1) Using price-tracking alerts encourages excessive trading and “suboptimal” market timing, and 2) The group that used price tracking alerts saw a decline in investment performance of about 1% in 6 months (2% a year). Why did the group that utilized the price alerts underperform? Because the price alerts made traders cocky and because a lot of the traders were financially illiterate and didn’t understand what they were doing. Behavioral biases are a big problem with traders The authors found that trading on price signals “intensifies overconfidence bias.” In plain English, it means that these trading signals gave traders an advantage they thought they had but did not really exist. They provided no informational advantage. These signals also made them trade irregularly and made them focus on assets that were less familiar to them, all of which can cause underperformance. Financial illiteracy is a big problem These trading signals give the illusion that traders somehow know what they are doing, but they don’t. The authors found that “insufficient financial knowledge” was a major problem, citing inexperience and even “superstitious trading.” The conclusions are consistent with other studies The study has some limitations: The data was gathered from a single trading platform, and the observations were gathered from trading and performance of fund portfolios and do not account for other trading activities, such as investing in stocks or real estate. Still, the results are consistent with other studies that show that active traders consistently underperform the market. Larry Swedroe, head of financial and economic research at Buckingham Strategic Wealth, in a recent review of several of these studies noted that while financial technology tools like digital trading platforms do improve the information environment, “they also cause investors to falsely believe they have better control over their portfolios and/or superior knowledge of the market.” “The tools can also exacerbate the cognitive biases of retail investors, creating a false sense of urgency and pressure to trade, resulting in increased trading and gambling-like behaviors, both of which lead to underperformance,” he added. Do digital trading platforms have any responsibilities to their clients? The authors suggest they do. They said that “comprehensive risk disclosure, including performance summary statistics on FinTech tools, can help alert investors to potential risks.” What can be done? The SEC is worried too The SEC has expressed concerns over these digital trading platforms, including ones that provide price tracking alerts, which may be encouraging excessive trading. They have expressed concern that these practices may violate the Regulation Best Interest guidelines, which requires brokers and dealers to act in the best interest of their clients. Ultimately, the authors suggest it gets down to making traders smarter. “Our study suggests that financially educated investors are better equipped to make sound decisions, even given potentially misleading alerts. We recommend that regulators and the financial industry collaborate to provide financial education support or, at a minimum, implement screening measures to safeguard individual investors.” The Financial Industry Regulatory Authority (FINRA) has already floated proposals that retail traders should pass a knowledge-based test on investment before trading in unfamiliar products, which I wrote about last year . Without better education, traders are going to make the same mistakes over and over.
This story originally appeared on CNBC
