Many amateur investors are so bad at playing the market that they would be better off choosing stocks at random, new UBC research has shown.
The study – from the Sauder School of Business – found that less experienced investors are failing to diversify and thus exposing themselves to enormous risk.
For their experiment, researchers asked participants to create a financial portfolio using tables showing previous returns.
Those with the least experience tended to pick positively correlated assets – eg, oil and forestry – which tend to increase and decrease in value together.
More experienced investors, meanwhile, know that they have to hedge their bets and include negatively correlated assets that move up when others move down.
"An amateur investor might buy stocks in lumber, mining, oil and banks, and believe they are diversifying because they're investing in different companies and sectors," said David Hardisty, study co-author and assistant professor at UBC Sauder.
"But because all of those equities tend to move in unison, it can be quite risky, because all the assets can potentially plunge at the same time."
The study explained: "The effect is so pronounced that many amateur investors would be better off choosing stocks at complete random."
One of the reasons the inexperienced investors were choosing correlated assets was because they deemed them to be less complicated and more predictable.
"If it seems predictable, it seems safer and easier to track," said Hardisty.
"Whereas if you have a combination of assets that all go in different directions, it seems chaotic, unpredictable and riskier."
Ironically, when the participants in the study were told to make riskier investments, they tended to diversify far more.
"This shows that amateur investors rely on a definition of risk that greatly differs from the objective definition of portfolio risk," said Yann Cornil, assistant professor at UBC Sauder and co-author of the study.
"This can lead them to make objectively low-risk investments when they intend to take risk, or to make high-risk investments when they intend to reduce risk."
Hardisty said he hopes the research will help amateur investors avoid potentially catastrophic losses on the market.
"If you don't diversify, when one asset does well the other ones are also going to do well,” he explained.
“But if one does badly it's likely the others will all do badly – and in investing, you want to avoid those worst-case scenario."
He added: "In the best-case scenario you could make lots of money and have an extra vacation or buy a car or something like that," he explains of the positively correlated accounts.
"But if your whole portfolio crashes you could risk losing your life savings. So, the best-case scenario isn't that much better, but the worst-case scenario is a whole lot worse."
