The Confidence Trap in DIY Investing

In the “good old days,” the flow of financial information moved at a very different pace. Before the turn of the century, financial news arrived through newspapers and analyst briefings held in stuffy conference rooms.

Today, like your dinner order, financial information is available with the touch of a button. Do-it-yourself (DIY) investors can now access real-time market data, earnings transcripts and analyst commentary instantly.

Investors can now also trade investments as quickly and often as they like. The introduction of digital trading platforms has played a major role in dramatically democratized investing. According to the Ontario Securities Commission, 45 per cent of all Canadian investors now have their own DIY trading account. But that surge of activity comes with risks.

Cory Hinds, an assistant professor of accounting at Smith School of Business, recently examined DIY investor behaviour and found that overconfidence is a significant factor influencing their decision-making. The motivation for this research stemmed from concerns raised by regulators about the design of digital platforms and whether certain features — such as highlighting market benchmark returns — may encourage overconfidence, excessive trading and poor performance.

“Overconfidence is something that's been studied a lot in the academic literature in both accounting and finance, and it's been shown to lead to suboptimal decisions, specifically in finance and in accounting. Investors who exhibit overconfidence tend to trade more actively,” he says.

Active trading can be particularly hazardous for DIY investors. Frequent buying and selling increases costs through trading fees and often reflects an attempt to time the market.

Research shows investors are generally more successful when they hold a diversified portfolio over the long term. Markets tend to rise over time, allowing patient investors to benefit from that growth. However, investors who try to jump in and out of the market risk missing gains or making poorly timed decisions that lead to losses. Investors who also concentrate their money in only a few stocks increase their overall risk.

Conventional wisdom would suggest that providing more information, such as benchmarks (market indexes like the S&P 500 or TSX which investors use to evaluate their portfolio performance), would help improve DIY investor decision making. But through a unique experiment, Hinds found the opposite was true.

“For investors who outperform these benchmarks, confidence can increase, making them less likely to adopt passive investing approaches going forward, even though research suggests those strategies tend to produce stronger long-term results,” he says.

Online trading game proves the theory

To test the influence of market benchmarks on investor behaviour, Hinds ran an online trading experiment with 194 participants who had some investing experience. Each participant was given $10,000 in hypothetical money to trade over a four-week period, with different groups trading during different times to mimic various market conditions.

At the start, participants estimated what their account balance would be at the end of the simulation. After the first week, all investors saw their results, but only half were also shown the market benchmark, forming the “Benchmark Group,” while the others became the “No Benchmark Group.” After reviewing their performance, participants then updated their predictions.

Overconfidence was measured by comparing each investor’s final prediction with their actual ending balance. The study also tracked trading activity on the platform, including how much participants invested in a passive index fund, to see whether exposure to benchmarks changed their investment strategy over time.

The results showed that participants who had outperformed the market actually reduced their investment in index funds after seeing the benchmark, suggesting they became less likely to follow a passive strategy. In contrast, participants who had underperformed the market did not significantly change their behavior, continuing to invest in passive strategies at roughly the same level as before.

What the research means going forward

Hinds hopes his research will reach DIY investors and help them recognize behavioural patterns that can improve how they invest. A positive aspect of digital platforms, he says, is they have opened the door for many new investors who might otherwise leave their money sitting in bank accounts earning interest that fails to keep pace with inflation. However, the tendency for overconfidence and frequent trading can lead some investors to perform worse than they would with a simple passive strategy. In some cases, they may even lose most of their investment.

“That’s the group we’re most concerned about. Some of the strategies these platforms use may be encouraging DIY investors to make decisions that are so risky they end up losing a lot of money,” Hinds says. “I’m hoping this research can help these investors make better decisions and avoid taking risks they otherwise might not.”

Despite these findings, Hinds is reluctant to support strict regulatory requirements for digital trading platforms, noting that doing so could limit choice for DIY investors. He acknowledges that many individuals want access to the same opportunities as institutional investors and that these platforms are largely responding to that demand.

Yet what appears to be seemingly neutral or informative features on digital platforms can have important consequences for investor confidence and investment decision making.

Hinds believes regulators could play a role by examining how investing information is presented to investors on digital platforms, including push notifications, visual cues and other trading tools. That would also include whether digital trading platforms should be required to provide certain types of information more clearly.

“I’m hoping this research helps investors make more informed choices,” Hinds says. “It can also prompt regulators to think carefully about how information is presented so people have what they need to help them navigate the markets.”