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Gamblers beware: the stock market bites back

by Don MacDonald, Montreal Gazette

April 1, 2005

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Do you play the stock market like a lottery? Take your time. The answer probably means several thousand dollars a year to your portfolio.

A fascinating new research paper entitled Who Gambles in the Stock Market? concludes that individual investors have a tendency to purchase stocks that have the characteristics of lottery tickets.

Just like the action at your nearest Loto-Quebec kiosk, many investors are trying to make a big score in the stock market, and, in the process, are throwing away their money.

The study's author, Alok Kumar, a University of Notre Dame finance professor, examined the trading records of tens of thousands of individual investors at a major U.S. brokerage firm.

He found individual investors are attracted to highly speculative stocks that look like they could pay off in a big jackpot. He calls them lottery-type stocks.

What are their characteristics? Typically, they have produced a few, large returns that catch the investor's eye, even if they have produced many smaller losses and a poor long-term track record.

They also tend to be volatile in a way that can't be explained by the movement of the overall market or the economy. And they have low prices. Many mining companies and technology firms would fit the bill.

"These investors are willing to take many small losses in hopes of a big jackpot," Kumar said in an interview.

Tellingly, these are just the kind of stocks that professional investors - pension and mutual-fund mangers - shun.

They prefer low-volatility, higher-priced stocks with a positive five-year return - blue chips, in other words.

The biggest players of lotteries tend to be poor and uneducated. A similar pattern emerges from the brokerage data Kumar studied - poorer and less educated investors are the most likely to buy speculative, lottery-like stocks.

As in gambling, these investors are looking for an easy way to a better life.

They may engage in this activity because they misjudge - just like many lottery players do - how lousy the odds are of hitting the jackpot. Or they may focus on the size of the prize and ignore the high probability of losing.

Whatever the reason, Kumar's research indicates that investors who choose to be stock-market gamblers pay a heavy price for their dream of making a killing. On average, their portfolios underperformed by about $3,600 a year, or five per cent of their annual income, compared with an investment in a passive index fund.

Of course, the toll in terms of percentage of annual income was much heavier on poorer investors, as high as 32 per cent for those earning less than $15,000.

Kumar says the message of his study is that people who are prone to gambling or risk-taking activities should steer clear of investing in individual stocks.

It's not hard to take that advice one step further, especially when Kumar's findings are taken in conjunction with earlier research conducted on the same database of brokerage accounts by University of California professors Brad Barber and Terrence Odean.

That pair of researchers found investors are terrible at picking winning stocks in general.

One of their findings: stocks that investors sold outperformed those they bought by 3.2 per cent on average over a year.

They also found that investors who traded the most earned an annual return of 11.4 per cent, compared with 17.9 per cent for the market as a whole.

Add it all up and the conclusion is clear. Individual stock-picking is a gamble most investors can't afford.