How trigger-happy traders lose money online

Online trading has many advantages. But before you hit the 'trade' button on your keyboard, think again, says Tim Bennett. Here, he explains the major problem with online trading, and what you can do about it.

The internet has made investing easier. But trading online can hammer your profits. Here's why and what you can do about it.

Why investors move online

Online trading has many advantages. It's faster, usually cheaper and you don't have to wait until your broker gets to the office to place an order. Better still, there is a vast amount of information online that you can't get anywhere else not even by chatting with a broker.

But there lurks a big bear trap for the unwary trader. Faced with all this information, and a trading system enabling us to deal at the touch of a button, we are all prone to get trigger-happy.

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The $160bn trap

"One rule of thumb suggests that US investors gave up $160bn dollars in 2010 through this hyperactivity," says the Psy-Fi blog. That's great news for a beleaguered securities industry, but really bad news for investors.

The number came from research by professors Brad Barber, Yi-Tsung Lee, Yu-Jane Lui and Terrance Odean at the Guanghua School of Management. They analysed the Taiwanese market and showed that a private investor's losses equated to a 3.8% performance penalty, equivalent to 2.2% of Taiwanese GDP between 1995 and 1999.

Taking the equivalent US loss as nearer 2% a best estimate, concedes the Psy-Fi blog and applying it to 2010 US census data on the cumulative value of US stock holdings $8,147bn gives you the $163bn. That's roughly 1.1% of US GDP for 2010, or $527 per head of population.

This calculation is based on some guesswork. But even if the true figure is lower, it suggests investors are throwing away a lot of money unnecessarily. Why?

Over-optimism meets pig-headedness

It's mostly down to "optimism bias", says Dylan Grice at Socit Gnrale. Studies show that we overestimate our odds of getting a pleasant surprise ("a gifted child") and underestimate the odds of a nasty one ("a road accident"). Without this bias we'd never take risks. The species would never have ventured beyond the cave entrance and traders would never make, or lose, money.

However, notes Grice, traders fail to realise we are also "impervious to evidence telling us we are wrong, and steadfast in our refusal to incorporate such evidence When the facts change, we change our prejudices." That's when things can get expensive for an investor, convinced they are right and Mr Market is wrong.

Grice cites a paper How unrealistic optimism is maintained in the face of reality' by three researchers working at University College London and Berlin's Freie and Humboldt State universities.

Participants rated their chances of falling victim to adverse life events, such as depression or vandalism. They were shown the average probabilities for each individual based on their social-cultural background.

Finally, they were asked to give a new estimate. The result? If the participants were given a real percentage (say a 20% probability) below their own estimate (say 30%) they'd make a big downward adjustment to their next estimate.

However, if they'd started with, say, 5% and were told the real statistic was 20%, most would only revise upwards by a few percentage points and find reasons why the new data didn't apply to them.

As investors, we prefer data that justify our decisions to data that reveal we screwed up. That's not rational, but it is human. Sometimes it's also acceptable Nobel Laureate psychologist Daniel Kahneman calls overconfidence "the engine of capitalism".

But it can be expensive. You can be lulled into taking inappropriate risks, running losses too long or piling good money after bad. Move online and securities firms can prey more easily on this weakness.

Why we hit the online trade button so often

The internet enables securities firms to bombard investors with news, analysis and tips in a way that's tough to replicate by post or over the phone. Advertisements often encourage you to seize every opportunity "Don't miss out, trade now!" They play on every investor's overconfidence with promises of immediate gains.

Yet there are no free lunches online or offline. You are often invited to trade after institutional traders have made a move the "information asymmetry" problem. And if a profit is guaranteed, why are you being told about it? But with many of the most tempting trading offers online, such as reduced fees for frequent trading, it can be tempting to abandon previous caution. So what to do?

What you can do

If you are thinking of a move to online trading, don't be put off the benefits are enormous in terms of the extra information available, plus you can save time and money.

However, don't abandon a methodical trading approach in the process. If you always reviewed your portfolio offline with your broker once a quarter and only traded existing holdings to rebalance it, then stick to that approach.

Ignore investing noise' designed to get you to buy or sell. If you are tempted, follow Winston Churchill's advice on exercising lie down for a while and let the urge pass.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.