Are individual investors dumb noise traders

Abstract

Purpose– The purpose of this study is to question the undifferentiated treatment of individual traders as “dumb noise traders?”. We question this undifferentiated verdict by conducting an analysis of the cognitive competence of individual investors.Design/methodology/approach– The authors let experts (both experienced researchers as well as practitioners) assess the mathematical and verbal reasoning demands of investment tasks investigated in previous studies.Findings– Based on this assessment, this paper concludes that individual investors are able to perform a number of complex cognitive actions, especially those demanding higher-order verbal reasoning. However, they seem to reach cognitive limitations with tasks demanding greater mathematical reasoning ability. This is especially unfortunate, as tasks requiring higher mathematical reasoning are considered to be more relevant to performance. These findings have important implications for future regulatory measures.Research limitations/implications– This study has two non-trivial limitations. First, indirect measurement of mental requirements does not allow authors to make definite statements about the cognitive competence of individual investors. To do so, it would be necessary to conduct laboratory experiments which directly measure performance of investors on different investment and other cognitively demanding tasks. However, such data are not available for retail investors on this market to the best of the authors’s knowledge. We therefore think that our approach is a valuable first step toward understanding investors’ cognitive competence using data that are available at this moment. Second, the number of analyzed (and available) tasks is rather low (n= 10) which limits the power of tests and restricts the authors from using more profound (deductive) statistical analyses.Practical implications– This paper proposes to illustrate information in key investor documents mostly verbally (e.g. as proposed by Rieger, 2009), compel exchanges and issuers of retail derivatives to create awareness for the results of the reviewed studies and our conclusion and to offer online math trainings especially designed for individual investors to better prepare them for different trading activities, as these have been shown to be as effective as face-to-face trainings (Fredericksonet al., 2005; Karret al., 2003).Social implications– This study can only be considered as a first step toward understanding the cognitive limitations of individual investors indirectly and could be transferred to other market areas as well.Originality/value– This study is the first to combine the assessment of outstanding researchers in this field with the results of previous studies. In doing so, this paper provides an overarching framework of interpretation for these studies.