All that glisters is not gold

A few years back one of the more popular investment myths - along with a belief that in the long term shares went up in value - was that if you followed a stock or a sector closely and were able to get information quickly you could trade profitably.

Men liked the idea because it reinforced their exaggerated self-image. Stockbrokers ran with it because more information, fed regularly to more confident clients, meant more turnover.

Fund managers pushed the story as another good reason for "Mum and Dads" to hand over their affairs to someone in the know, i.e. them. And internet providers didn't have a clue how it would make them money but lots of hits on their website had to be good news, right?

A great many investors readily embraced the concept that knowledge is power and logged on with an expectation that wealth, happiness and girls were just a few mouse-clicks away.

Alas, the stockmarket crash dashed those dreams and the internet trading model has been shelved for a while.

But does being logged on, in the information loop, close to the action, give an investor any advantage anyway? A recent study suggests that such a strategy, like much of the recent dotcom boom, is a bit like a gold rush without the gold.

Brad Barber and Terrance Odean of the University of California looked at the behaviour of individual retail (as opposed to institutional) investors and concluded that most resolve the problem of choosing which shares to buy by considering for purchase only those stocks that have recently caught their attention.

The authors suggest that while a lot of research has been done on retail investors' selling decisions, comparatively little is known about their buying, yet the choice of which shares to buy is potentially more challenging than what to sell.

When selling, most investors consider only the stocks they already own (in some places, such as the United States, it is legal to sell shares you don't own).

Choosing which stock to buy presents investors with a huge search problem. Thousands of possibilities exist in the US and quite a number are still left in this country.

But human beings have limited mental processing abilities. Without a computer it would be extremely time consuming, if not impossible, for most investors to evaluate the merits of every available share.

The authors argue that while investors don't buy every stock that catches their attention, they buy far fewer that don't.

Within the group of stocks that do attract their attention, investors are likely to have personal preferences, but whatever his or her strategy, an investor is less likely to purchase a stock that is out of the limelight.

The Barber/Odean study found that many individual investors display "attention-based buying behaviour"; they buy when stocks are in the news and following extremely negative or positive one-day returns.

Indeed, a number of financial websites - including the Herald's - allow the investor to filter shares to show only those whose prices have moved the most, and will also automatically alert the investor when news is published. The study found that clients of large discount broking firms tend to be net buyers of both the previous day's big winners and big losers.

In contrast, professional investors are less likely to indulge in attention-based purchases. With more time and resources, professionals are able to continuously monitor a wider range of stocks.

They are unlikely to consider only attention-grabbing stocks.

This is a little perverse; the advertising of fund managers says "let us manage your funds because we are up with the play" yet part of their advantage comes from ignoring stocks which are in the news.

Professionals are likely to employ explicit purchase criteria, perhaps using software, that circumvent attention-based buying. And many professionals might solve the problem of searching through too many stocks by concentrating on a particular sector or on stocks that have passed some initial test.

They are more likely to be buyers of stocks which aren't in the news and to use computer programs to sort all the available stocks according to explicit search criteria, for example, by asking their computers to find stocks with a high dividend yield and forecast profit growth of 10 per cent a year.

So how do you choose the shares you buy? Look at your portfolio - do you have a strategy and specific search criteria or are your purchases randomly based on whatever jumps on to your screen.? Or is your portfolio dominated by floats which your broker drew to your attention?

In the US there is apparently an inordinate number of individual Cisco and Worldcom shareholders. It is probably the same in New Zealand, because back in 1998-2000 these stocks were in the news all the time and attracted people's attention.

The Barber/Odean study has major implications for the thousands of retail share investors in this country, as many will one day depend on their savings to fund their retirement.

Understanding New Zealand's trading weaknesses might improve investment strategies, and thus returns.

The study found that the portfolios of investors exhibiting attention-based trading strategies underperformed against the market average.

Barber and Odean conclude by saying that in previous studies they found that most investors do not benefit from active trading.

On average, the stocks they buy subsequently underperform those they sell and the most active traders underperform those who trade less.

"We believe that most investors will benefit from a strategy of buying and holding a well-diversified portfolio.

"Investors who insist on hunting for the next brilliant stock would be well advised to remember what California prospectors discovered ages ago: All that glisters is not gold."

* Brent Sheather is a Whakatane investment adviser.