Posted by: Ben Steverman on November 20, 2007
New research suggests widespread use of limit orders may be one reason individual investors do poorly when trading stocks.
When they trade their own stocks, amateur investors tend to underperform the market. Research shows the more they trade, the more they tend to lose. Even as taxes, fees and trading costs eat into returns, individual investors also tend to make poor choices, buying losing stocks and selling winners. That’s why many experts recommend simple index funds for most investors.
University of Chicago Graduate School of Business professor Juhani Linnainmaa is out with new research on the use of limit orders. When investors buy stock, they can either place a market order, paying the current market price, or a limit order, which will only be executed if the stock falls to a certain price.
Here’s the problem, Linnainmaa shows: When new news comes out on a stock, limit orders go “stale” but amateur investors are rarely able to withdraw their old limit orders in time. He writes:
A stale limit order does not reflect current market information. … The problem is that individual investors don’t have the resources to constantly monitor the market, which places them at a disadvantage relative to institutional investors.
When news breaks, quick-acting traders take advantage of all those stale limit orders, reaping profits while amateur investors lose out.
Limit orders are popular among individual investors. Linnainmaa, using data from a U.S. discount broker, estimates almost 75% of individuals’ orders are the limit variety.
Despite his findings, he says investors might still use limit orders in some cases. But don’t set limit orders so low that they’ll only be executed in the event of news, he adds.