[Paper Review] Do investors trade too much? A laboratory experiment

João da Gama Batista, Domenico Massaro+3 more|arXiv (Cornell University)|Dec 11, 2015

Complex Systems and Time Series Analysis81 references21 citations

TL;DR

This laboratory experiment investigates why investors trade excessively despite clear financial disincentives. Using a controlled market with a known, high-return asset and explicit price impact, the study finds that subjects trade far too much—driven by risk-seeking behavior and profit-seeking expectations—resulting in significantly lower wealth, even though a simple buy-and-hold strategy would yield over 600% returns.

ABSTRACT

We run experimental asset markets to investigate the emergence of excess trading and the occurrence of synchronised trading activity leading to crashes in the artificial markets. The market environment favours early investment in the risky asset and no posterior trading, i.e. a buy-and-hold strategy with a most probable return of over 600%. We observe that subjects trade too much, and due to the market impact that we explicitly implement, this is detrimental to their wealth. The asset market experiment was followed by risk aversion measurement. We find that preference for risk systematically leads to higher activity rates (and lower final wealth). We also measure subjects' expectations of future prices and find that their actions are fully consistent with their expectations. In particular, trading subjects try to beat the market and make profits by playing a buy low, sell high strategy. Finally, we have not detected any major market crash driven by collective panic modes, but rather a weaker but significant tendency of traders to synchronise their entry and exit points in the market.

Motivation & Objective

• To investigate the root causes of excess trading in financial markets under controlled conditions.
• To examine how individual risk preferences and expectations influence trading behavior and wealth outcomes.
• To assess whether synchronized trading activity leads to market instability or crashes.
• To measure the impact of market microstructure features such as price impact on investor welfare.
• To compare actual trading behavior with rational, buy-and-hold strategies in a setting where the optimal strategy is unambiguously known.

Proposed method

• Conducted laboratory asset market experiments with artificial, risk-free assets that grow predictably at a known rate over time.
• Implemented a market maker mechanism with explicit price impact, modeling real market friction where trades affect asset prices.
• Used a finite but indefinite time horizon to avoid backward induction failures common in prior experimental designs.
• Collected traders' risk preferences via Holt-Laury paired lottery choices to correlate risk attitude with trading activity.
• Gathered real-time price predictions from subjects each period to link expectations directly to trading decisions.
• Analyzed trading volumes, price trajectories, and wealth outcomes across multiple experimental sessions to assess market stability and individual performance.

Experimental results

Research questions

• RQ1 Why do investors trade excessively even when a buy-and-hold strategy guarantees a return of over 600%?
• RQ2 How do individual risk preferences influence trading activity and final wealth in experimental markets?
• RQ3 To what extent do traders' expectations of future prices drive their buy/sell decisions?
• RQ4 Does synchronized trading activity lead to market crashes or instability in the absence of panic or extreme volatility?
• RQ5 How does the implementation of price impact affect the collective welfare of market participants?

Key findings

• Subjects traded excessively despite knowing that a buy-and-hold strategy would yield over 600% returns, resulting in average profits close to zero in first sessions.
• Repeated participation improved performance, with average returns rising to 92%, but still significantly below the theoretical maximum.
• Higher risk preference was systematically linked to higher trading activity and lower final wealth, confirming a behavioral bias in trading decisions.
• Traders' actions were fully consistent with their expectations: they actively tried to time the market by buying low and selling high.
• No major market crashes or panic-driven sell-offs were observed; instead, there was a weak but significant tendency for traders to synchronize entry and exit points.
• Price impact acted as a transaction cost that eroded returns, demonstrating that excessive trading harms collective welfare even in a risk-free, predictable environment.