Although she holds a PhD in economics, she did not sell as prices began to plummet, displaying a typical “disposition effect” as she was reluctant to realize capital losses. Her response was exactly like many other Chinese investors.

Collectively, individual investors are the major player on the Chinese stock market, but the majority of them suffer losses. For example, a survey by the China Securities Journal found that 70% of Chinese investors in the secondary market suffered average losses of 40,000 yuan (US$6,300) per account in 2010.

How do Chinese individual investors trade? The most popular source of information used to reach a trading decision is news (or rumors) passed on by friends and relatives. Investors overestimate the precision and value of such information and so are subject to an over-confidence bias. With this “inside” information, they feel they are trading like predators, but all too often, they are victims as the information is either wrong or already widely known.

Individual investors without access to such information tend to follow the trading decisions of others. This means that herding is a common phenomenon among individuals on the Chinese stock market.

WHY DO THEY TRADE? Asian people like to gamble, which is often said to be ingrained into our cultural heritage. Such behavior is also seen on the stock market, which many people enter hoping to make a quick speculative gain.

This can cause excessive trading and high turnover ratios. That the dividend yield is low does not seem to deter many. Most investors know little or care even less about intrinsic values because stocks are just tools for gambling. On the stock market itself, excess trading based on beliefs or information that has little relation to fundamental value can cause noise trading and increase volatility. Then, the stock market behaves like a casino: reallocating money rather than generating wealth.                         

For individual investors, the result can be worse than a zero-sum game after taking taxes and brokerage fees into account. But this does not halt overconfidence. Huge speculative trading has come to dominate rational investment decisions so much that, ironically, “shareholder” is now a term in China for someone who speculates on stocks, loses the gamble, but remains reluctant to sell.        

The 2007-08 Chinese stock market bubble was a disaster for individual investors. Hopefully, they learned from it. In May 2007, the Shanghai Composite Index passed the 4,000 level, with a price-to-earnings ratio of 70. I discussed this in my investments class at the University of Texas. US college students thought the price quite inflated, but at the same time, college students in China were eagerly taking out loans to buy hot stocks. The index peaked at 6,000 in October 2007 and collapsed to 2,600 in June 2008. Many individual investors lost heavily, believing that the Chinese government could not let the bubble burst before the Olympic Games in the summer of 2008. Unfortunately, they forgot the invisible hand of the market.

One poor guy lost all his money through leveraging. He was interviewed on television and, when asked why he had invested that much, said, “I wanted to make enough money for the rest of my life in one or two years from the stock market. It’s the only chance in my life and I couldn’t miss it.” It was partly greed, partly naivety and all of it combined into a tragedy.             

THE BEHAVIOR OF individuals has also complicated the Chinese stock market for institutional investors. Noise trading and herding of individuals can cause high volatility, so the government expanded the mutual funds industry to stabilize the market. Unfortunately, investors in mutual funds also tend to display the same short-term attitudes as individual stock market investors. Under “redemptive pressure” by fund investors, who will withdraw their backing if dissatisfied with performance, the funds are similarly exhibiting tendencies towards short-termism, herding and disposition effects.

In addition, high-churn trading makes it expensive for institutions to conduct normal arbitrage; that is, buy undervalued stock and sell overvalued stock. High-noise trading often pushes the price further away from the fundamental value, so it is not surprising that institutions sometimes find themselves chasing trends or riding bubbles.

When the Shanghai Composite Index hit the 5,000s in late 2007, a senior economist from a top investment bank stated: “I don’t think that this is a bubble and it will keep rising to 10,000.” Naive individuals were apparently encouraged to back the bubble to last longer, so institutions could leave in time with pockets full of cash.

Compared with institutions, individual investors are disadvantaged in terms of information and professional knowledge. They are also more vulnerable to deceptive practices and insider trading. For example, institutions could mislead individuals by spreading rumors or manipulating price change.

IN THE CURRENT ENVIRONMENT, many individuals are losing money in the stock market and are complaining loudly. But, many more are still willing to play, even though the game can be unfair and difficult. However, the simple fact is everyone is bullish about the possibility of their personal success and they have no sympathy for losers until they themselves become one. So, there is little empathy or solidarity between other individual investors, meaning there is no chance of them banding together to agitate for fairer trading.

Of course, some individuals do benefit from institutional trading, but this is not always legal. For instance, if you know which stock will be bought ahead of a large purchase by a fund, you can get in first. This is usually related to inside information and is known as “rat trading” in China. 

When I was a doctoral student of finance, a college friend suggested at a party that I “should work for mutual funds and then we can work together to make money.” He meant rat trading, which is illegal and carries significant penalties. As I went on to become a university professor, I was of little value to him so we have since lost contact.

How prevalent such behavior is on the Chinese markets is impossible to gauge. But, in China as elsewhere, short-termism and utilitarianism can not only affect people’s attitude towards life, but also override inclinations to be rational investors.