Qualitative Research in Financial Markets

Are individual investors dumb noise traders: An analysis of their cognitive

competence based on expert assessments
Philip Blonski, Simon Christian Blonski,
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Are individual investors dumb Dumb noise

traders?
noise traders
An analysis of their cognitive competence
based on expert assessments 45
Philip Blonski
Received 16 February 2015
Chair of Banking and Finance, University of Hagen, Hagen, Revised 2 June 2015
Germany, and Accepted 1 September 2015

Simon Christian Blonski

Psychologist, Hanover, Germany
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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

JEL classification – G11, G14, G21 Qualitative Research in Financial

We thank Benjamin Newell from the psychology department of the University of New South Markets
Vol. 8 No. 1, 2016
Wales for valuable comments. This paper is based on the PhD thesis of Philip Blonski which was pp. 45-69
supervised by Professor Dr Rainer Baule. We thank Rainer Baule for very helpful comments on © Emerald Group Publishing Limited
1755-4179
this paper. DOI 10.1108/QRFM-02-2015-0009
 QRFM activities, as these have been shown to be as effective as face-to-face trainings (Frederickson et al., 2005;
Karr et al., 2003).
8,1 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
46 of interpretation for these studies.
Keywords Financial literacy, Behavioral finance, Cognitive abilities, Retail derivatives,
Retail investors
Paper type Research paper

1. Introduction
The market for retail derivative products has experienced a rapid growth over recent
decades. The current market volume of outstanding products in Germany alone
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amounts to approximately €90 billion and to more than €700billion in Europe. Banks
and other financial institutions issue a wide assortment of financial instruments that
require no minimum trading lots and are thus particularly designed for individual
investors. Retail derivatives allow investors to follow more sophisticated (e.g. leveraged)
trading strategies than classical instruments like stock investments alone. The German
market for retail derivatives is highly sophisticated and offers investors a range of more
than 1.1million different outstanding products.
However, recent literature shows that individual investors often do not act rationally
when making an investment decision. Most often they do not even behave particularly
skillfully[1]. Black (1986) simply dismisses individual investors as “noise traders”.
Meyer et al. (2014) conclude that individual investors do not have any “predictive power
whatsoever” and simply seem to be “decreasing their wealth to indulge in the adrenaline
of trading highly leveraged products” (Meyer et al., 2014, p. 16.). Schroff et al. (2013)
recap their findings as follows: “Overall, individual investor trading in leverage
products is not particularly skillful”. Barber and Odean (2013) describe the trading
competence of individual investors as “perverse” (Barber and Odean, 2013, p. 1541).
Additionally, individual investors have been found to possess rather low financial
literacy (Lusardi and Mitchell, 2007; Lusardi et al., 2010), while Célérier and Vallée (2014)
conclude that banks exploit retail investors’ low financial literacy and sophistication by
increasing product complexity which in turn decreases investor returns and increases
bank returns. Finally, De Bondt (1998) and Frazzini and Lamont (2008) clearly state that
individual investors are dumb. The importance of these findings becomes even clearer
against the background of the recent financial crisis in 2008 during which individual
investors lost a significant proportion of their wealth, partly due to uninformed trading.
Referring to individual investors as dumb noise traders with perverse trading
strategies is mainly based on the finding that they realize low or even negative (risk
adjusted) returns on average (Barber and Odean, 2013; Bauer et al., 2009; Henderson and
Pearson, 2011; Entrop et al., 2014b). However, the low profitability of individual
investors can have a variety of reasons (e.g. external market factors, and bank margins)
and is not necessarily linked to their low cognitive competence. Probably, one of the
most important motives for trading retail derivatives – as opposed to classical
investment products (Barber and Odean, 2013) – is a distinct desire for gambling and
 speculation (Meyer et al., 2014; Bauer et al., 2009; Schmitz and Weber, 2012, Rieger and Dumb noise
Hens, 2012). Thus, investors might be willing to accept substantial risks leading to traders?
negative returns on average (Entrop et al., 2014b), because they draw utility from the
possibility of overproportional gains (or from considering trading itself as
entertainment as shown by Grinblatt and Keloharju, 2009; Dorn and Sengmueller, 2009).
Therefore, trading retail derivatives and averaging negative returns are not necessarily
dumb; it might merely reflect a certain attitude to risk and a desire to seek sensation on 47
the part of some investors. Due to this ambiguity, we consider it worthwhile to
investigate the actual cognitive competence and financial literacy of individual
investors in more depth.
For the present paper, we are interested in studies examining the trading competence
of individual investors in retail derivatives. We first conduct a comprehensive literature
analysis in Section 4. We identify ten investment tasks performed by individual
investors trading at the market for retail derivatives. For each of these tasks, we briefly
describe the research question and the cognitive actions related to the investment
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behavior under investigation. We constructed a survey presenting this information for

each task and asked experts (practitioners, authors of the studies under investigation
and other financial researchers) to judge the cognitive demand of investment behaviors
analyzed in these previous studies. In our view, only finance experts with their thorough
knowledge of financial behavior and retail derivative products are able to adequately
judge the cognitive demands of the investment behaviors we consider. Given these
restrictions, we think that our sample, comprising three groups of experts, is as
heterogeneous as possible. We then used the findings of these studies to determine
whether a task (and thus its mental demand) could be performed successfully by the
investors or not (task feasibility). Given a lack of direct measurements of the cognitive
abilities of individual investors, we think that this indirect procedure allows us to take a
first step toward understanding the cognitive abilities and limitations of individual
investors. Furthermore, compared to laboratory studies investigating cognitive
competence, our approach possesses higher ecological validity, as it investigates
cognitive competence in real life and not as a test.
For this expert assessment, we differentiated between mathematical and verbal
reasoning demand. We decided to use demands on verbal and mathematical reasoning
ability as proxies for overall cognitive demand because reasoning ability is an integral
part of general intelligence (Carpenter et al., 1990). More interestingly, degrees of
mathematical and verbal reasoning ability differ between individuals (inter-individual
differences, Lakin, 2013) and within individuals (intra-individual differences, ETS,
2010). These inter-and intra-individual differences might be highly interesting in the
context of our study as well. Furthermore, both kinds of reasoning convincingly
describe the cognitive actions required in the investment process, within which people
mainly have to understand, process and draw inferences from verbal and mathematical
information (high face validity).
Using experts as a source of information and characterizing the cognitive demands of
certain behaviors are two techniques more often used outside the field of behavioral
finance. Expert opinions have been used to make decisions in situations with a lack of
information and empirical data in many different disciplines (Cooke, 1991; Jones and
Hunter, 1995; Barendse et al., 2014); they are considered factual sources of information
in health-related fields (Sullivan and Payne, 2011; Rudwaleit et al., 2009) and form an
 QRFM integral part of the ranking of finance and accounting journals (Datt et al., 2009). Also in
8,1 ecology, studies have been conducted using expert opinions as the primary source on
which to base conclusions (Kuhnert et al., 2005; Kuhnert, 2011). In our survey, we
acquired responses from 50 experts (28 researchers and 22 practitioners), which is a
sample size superior to those of other studies relying on experts (Kuhnert et al., 2005;
Rudwaleit et al., 2009). Also the widely accepted German VHB ranking of journals is
48 based on expert opinions. Here, 25 experts are considered sufficient to include journals
into the ranking. To determine the reasoning abilities demanded for investment
behaviors, we were informed by the ideas of cognitive task analysis, which is a
commonly used technique to identify cognitive demands in different research and
application areas related to human performance (Clark et al., 2008; Schraagen et al.,
2000).
First, our results show that retail investors are able to successfully perform tasks
with reasonable mental demands. This is especially true for verbal reasoning. Second,
we provide evidence that the demand for mathematical reasoning is significantly higher
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for tasks that individual investors are not able to perform successfully than for those
they are. However, the demands for verbal reasoning are comparable for both groups.
Third, the mathematical demands of a task are highly correlated with the task’s
relevance to overall investment performance, whereas the correlation between verbal
demands of a task and relevance to performance is close to zero. Combining our second
and third findings, we conclude that individual investors are not “dumb”, they merely
possess the “wrong” cognitive abilities needed to achieve higher returns.
Our work contributes to the current literature by presenting a cognitive perspective
on the results of current papers studying the behaviors of investors on the market for
retail derivatives. The results of our study challenge the oversimple verdict that
individual investors are dumb noise traders. On the contrary, our findings are more in
line with Kelley and Tetlock (2013) who find that “researchers should take care when
using retail trading as an empirical proxy for noise trading” (Kelley and Tetlock, 2013,
p. 1263). We thus support a more nuanced differentiation between different kinds of
investor professionalism as do Vong and Trigueiros (2009) or Kuo et al. (2015).
The remaining paper is structured as follows: Section 2 elaborates the psychological
background of our analysis. Section 3 fits our review into the respective financial
background: While recent literature has mainly focused on the pricing behavior of
banks (see the short overview in Section 3), only a very limited number of studies deals
with investor behavior. The results of those studies that are linked to the cognitive
performance of investors are reviewed and interpreted in Section 4. Together with our
survey in Section 5, this chapter forms the principal part of the present study. Section 6
concludes with a discussion of our results.

2. Psychological background
Because of the lack of confidence of earlier investigators in the cognitive abilities of
individual investors (Black, 1986; Meyer et al., 2014), it seems appropriate to consider the
investment process from an information processing point of view, highlighting the
cognitive abilities and limitations of individual investors. To this end, we first provide a
short description of the general information processing system in relation to the
investment process.
 To invest in a structured product, several cognitive actions have to be performed, Dumb noise
ranging from basic information processing up to higher-order tasks such as reasoning. traders?
The execution of all of these divergent cognitive actions is restricted by the limited
resources available in the working memory’s central executive and storage components
(Baddeley, 1996, 2000; Logie, 2011; Baddeley and Logie, 1999; Piolat et al., 2005), i.e.
attentional control (Lavie et al., 2004; Burnham et al., 2013), temporary storage of
information (Narimoto, 2011; Loisy and Roulin, 2003), retrieval of information from 49
long-term memory (Unsworth et al., 2013; Kaumann, 2002; Conway and Engle, 1994),
different forms of reasoning (Oberauer et al., 2007; García-Madruga et al., 2007; see also
Oaksford et al., 1996), including the solution of arithmetic problems (Geary et al., 2012;
Ashcraft and Kirk, 2001) and the planning involved in multi-tasking (Law et al., 2006),
are all cognitive tasks which have been shown to be dependent on the capacity of the
storage systems and/or the resources of the central executive within working memory.
Not surprisingly, working memory capacity (WMC) has repeatedly been identified as
the best predictor of performance on intelligence tests (Oberauer et al., 2007), with
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differences in WMC supposedly underlying differences in general intelligence (Conway

et al., 2003). Generally, the working memory is considered as an information-handling
structure responsible for encoding, processing and maintaining information (Burnham
et al., 2013; Baddeley and Logie, 1999) and for on-line (Logie, 2011; Narimoto, 2011) as
well as complex cognition (Miyake and Shah, 1999). Thus, possible limitations of
investors in conducting divergent cognitive actions during the investment process are
likely to arise from limitations in WMC. Arguably, the cognitive actions imposing the
largest requirements on WMC during the investment process are higher-order cognitive
actions, specifically verbal and mathematical reasoning. Reasoning ability is the corner
stone of many definitions of fluid intelligence (the ability to solve novel problems
without the use of declarative knowledge, e.g. Carpenter et al., 1990) and can broadly be
understood as a cognitive process in which people use information available to them to
draw inferences (Blanchette and Richards, 2010). For example, reasoning refers to the
ability to recognize regularities and irregularities between concepts to formulate rules
and generalize (Klauer and Phye, 2008; Barkl et al., 2012) or to draw correct conclusions
from stated conditions or premises (Schrank, 2006). Thus, the investment process,
wherein investors have to understand the products they want to trade, decide which
information will likely enable them to best predict future development of these products,
and interpret this relevant information correctly, can be considered as mainly consisting
of a number of reasoning tasks. Several different forms of reasoning are relevant during
the investment process: Numerical or mathematical reasoning is required to interpret
quantitative data and to understand numerical relationships in general (Bennett et al.,
1990; Lohman and Hagen, 2001). Verbal reasoning refers to the ability to comprehend
and draw inferences from information presented in verbal form (Lohman and Hagen,
2001; Lohman, 2003; Lakin, 2012).
To sum up, after presenting the required financial background in the following
section, different investment behaviors investigated in prior research will be analyzed in
terms of their numerical and verbal reasoning demands.

3. Financial background
Demand for retail derivatives (also called securitized derivatives or structured products)
has increased dramatically over the past decades. Besides several Asian markets such
 QRFM as Hong Kong or Korea, the German market for retail derivatives is one of the largest
8,1 worldwide. The yearly turnover in Germany alone amounted to approximately €48bn in
2013 (DDV, 2014). Trading on classical options markets is most often not possible or
feasible for retail investors due to market restrictions or large commission fees. Retail
derivatives therefore effectively extend individual investor’s product universe.
After issuance, retail derivatives are traded at special exchanges, where the market
50 maker (and the counterpart for the investor) is the issuing bank itself and sets the prices
for their products. Hence, observed prices are not the direct result of supply and demand
(as normally observed in other markets) but are also heavily influenced by the
price-setting policy of the issuing company. There is a vast amount of literature which
finds that retail derivatives are more expensive than their counterpart on options
exchanges which are only accessible to institutional investors (Wilkens et al., 2003;
Baule, 2011; Stoimenov and Wilkens, 2007; Baule et al., 2008; Entrop et al., 2009;
Grünbichler and Wohlwend, 2005). The recognition of such markups challenges the
cognitive competence of individual investors and plays an important role in some of the
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studies illustrated in Section 4.

Structured products usually combine the payoff of an underlying (e.g. a stock or an
index such as the German market index DAX) with one or more option-like element(s).
The profit profile of the underlying is a simple 45° linear function. The option-like
element(s), however, are far more complex. Therefore, product complexity varies greatly
between products. Thus, from a cognitive perspective, the market for retail derivatives
provides us with a striking advantage over classical stock markets: pPayoff structures
for retail derivatives are more complex than those of stocks and differ from product to
product. This makes them ideal objects of investigation from a cognitive point of view,
as the demand for cognitive competence is positively correlated with payoff complexity.
Product complexity is also addressed in the survey in Section 5. Célérier and Vallée
(2014) analyze drivers of financial complexity and find that banks exploit the low
financial literacy of individual investors (Lusardi et al., 2010) by increasing product
complexity. They show that for a wide range of structured products, a higher degree of
product complexity is associated with lower investor performance.
Among the most successful retail derivatives are warrants, discount certificates,
turbo certificates and bonus certificates. Further popular products are capital protection
certificates, express certificates and worst-of-products. As these are the products
analyzed in Section 4, we initially briefly summarize their main features.
• Warrants: Warrants are securitized plain-vanilla options issued by banks. Thus,
their payoff diagrams correspond to those of classical put- and call-options.
Payoff diagrams of turbo certificates are comparable to warrants. However, they
additionally cease to exist if a certain level of the underlying is breached
(down-and-out-feature) which further increases product riskiness (and, arguably,
product complexity). These products magnify price fluctuations of the underlying
asset and are therefore referred to as leverage products. In other words, an
investment in leverage certificates enables investors to participate
disproportionately in value changes of the underlying.
• Discount certificates: Discount certificates enable investors to buy an underlying
at a discount from the current market value. As a compensation for this discount,
possible gains are capped at a certain level, that is, the payoff at maturity is either
the terminal underlying value or this level (cap), whichever value is smaller. In
 other words, this product corresponds to a combination of the underlying and a Dumb noise
short call. traders?
• Capital protection products: Capital protection products guarantee the payback of
a certain amount of invested money. The standard version of this kind of
certificate is a combination of the underlying with a put. In the end, the investor
pays the option premium as an insurance against capital losses.
• Bonus certificates: Bonus certificates feature a conditional capital protection. As 51
long as the underlying does not fall below a certain threshold (barrier) during the
certificate’s lifetime, the payoff is at least as high as the bonus level (usually equal
to the issue price). Otherwise, the payoff equals the underlying price at maturity.
• The payout of express certificates either occurs at the end of the product’s lifetime
or at a certain predetermined due date, depending on the development of the
underlying and a number of trigger events[2].
• Worst-of-products: Worst-of-products refer to a basket of underlyings. The
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payout of these products depends on whether at least one of the underlying values
in this basket falls below a certain threshold. If one of the products is below a
given barrier level, the payoff of the certificate is normally linked to the worst
performing underlying in the basket. Otherwise the investor earns high coupons
on his investment.

4. Tasks involved in investing on the retail derivatives market

This section presents ten different tasks analyzed in previous studies. The aim of the
following section is to analyze current research in terms of the cognitive actions required
to perform a certain task. We challenge the overlying simplistic generalization that
individual investors are “dumb noise traders” by conducting a task analysis and
surveying experts to analyze the trading behavior of individual investors in more depth.
We outline the tasks in this section and present the survey of experts afterwards in
Section 5.
The first three tasks analyzed in the present study refer to the prices and margins of
retail derivatives discussed in the section above. Baule and Blonski (2014) investigate
the sensitivity of individual investors regarding prices and margins on the warrant
market in the year 2009. In a first step, the authors investigate whether investors are able
to compare prices of similar products issued by different issuers and to invest in the
cheapest product. The authors call this skill “price sensitivity” (Task 1). Investing price
sensitively mainly requires cognitive abilities for monitoring the prices of (here: of
up-to-four different) competing products with comparable product characteristics and
choosing the cheapest product.
Afterwards, the authors analyze the sensitivity of investors with regard to margins.
This part of their analysis is based on the aforementioned finding that banks
incorporate a margin into retail derivatives prices above and beyond the theoretical fair
product values. Such a sensitivity to margins would require investors to first determine
theoretical fair product values for which additional market data and more expertise in
financial modeling are required (Task 2). The cognitive actions related to this
investment behavior are determining the fair value of the product based on theoretical
models and choosing the product with the lowest margin. Baule and Blonski (2014) find
 QRFM evidence that individual investors are able to invest price sensitively, but there is no
8,1 evidence of them investing margin sensitively.
As retail derivatives are prone to the default of the issuing bank, Entrop et al. (2014a)
investigate whether individual investors consider the default risk of the issuing bank
when making an investment decision (Task 3). The cognitive actions related to this
investment behavior are determining issuer default risk (e.g. based on CDS-spreads or
52 ratings) and accurately judging default risk when making an investment decision. In
this study, more than 72.000 single stock discount certificates were analyzed on a daily
basis from 2004 through 2008. The authors question whether investors are able to
determine the default risk of the issuing bank (e.g. based on credit default swap spreads).
According to their findings, investors do not consider issuer default risk when making
an investment decision.
The next four tasks analyzed here deal with the acquisition, perception and
interpretation of investment relevant news or information. Meyer et al. (2014) report on
the trading behavior of individual investors in turbo certificates on the German market
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index DAX and individual stocks from April 2009 to February 2010. Based on Thomson
Reuters NewsScope Content, the authors determine trading intensity especially after
news announcements (Task 4). The cognitive actions related to this investment
behavior are perceiving company-specific news and responding with an investment
decision. The authors find that trading activity increases significantly directly after
positive and negative news announcements, whereby profitability is comparably low
and negative for both news-driven and non-news-driven trades. The authors conclude
that individual investors have neither private information nor any predictive power
whatsoever, but do follow news passively.
Schroff et al. (2015) analyze the demand for information by individual investors in
more depth in a data set of almost 250,000 products (discount, bonus and leverage
certificates) from April 2009 to March 2012. The authors question whether individual
investors actively search for and make use of news made public via traditional news
channels such as newspapers or news-Web sites (Task 5). The cognitive actions related
to this investment behavior are monitoring company-specific news actively, using
Web-based search engines and discussion forums or blogs to actively search for news
and making an investment decision before news are made public via traditional media.
This requires investors to not only rely on market-wide news but to actively formulate
appropriate company-specific searches. Schroff et al. (2015) use Google-search statistics
to determine whether investors search for company-specific news actively before
making an investment decision. The authors find a positive contemporaneous
relationship between queries for firm-specific information and trading activity in
speculative products, partly even irrespective of information supply in the form of
conventionally distributed news. Fink and Johann (2014) come to similar results. These
findings show that investors indeed actively conduct Google searches autonomously to
discover more company-specific information before making an investment decision. In
fact, the authors find that information discovery often takes place in alternative
information channels such as discussion boards or blogs before news is published in the
traditional news media[3].
Schmitz and Weber (2012) analyze the buying and selling behavior of individual
warrant investors after price fluctuations of the underlying, which provides information
on whether individual investors are able to perceive the historical development of quotes
 (Task 6). The cognitive actions related to this investment behavior are acquiring Dumb noise
historical quotes, extrapolating the development of historical quotes into the future and traders?
deciding on the direction of the trading strategy (negative or positive feedback-trading).
Feedback-trading can be the result of a number of psychological biases, such as the use
of availability and representativeness heuristics. Past financial data are readily
observable and may be given an unjustified weight in predicting future development.
Although usage of heuristics is generally considered to require less cognitive effort (and 53
to simultaneously increase the likelihood of errors) in comparison to a more reasoned
decision-making process (Katsikopoulos, 2011), investors still need to perform basic
cognitive actions for a feedback-trading strategy. Schmitz and Weber (2012) use a data
set from a large German discount broker containing more than 1,400 investors and
almost 90,000 single transactions in the period from 1997 to April 2001. They show that,
on aggregate, individual investors follow negative feedback-trading strategies. Baule
and Blonski (2012) relativize this finding by differentiating between investors of
different degrees of professionalism. They show that the feedback-direction depends on
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investor professionalism and differs for puts and calls. Regardless of the actual direction
of feedback trading, both studies come to the result that individual investors do indeed
follow feedback-trading strategies.
Blonski (2014) analyzes another kind of perception of information. He conducts a
survey among potential investors (undergraduate students from a broad range of study
programs) with a total of 237 participants. The goal of this investigation was to analyze
the persuasibility of individual investors by economically irrelevant information. For
this purpose, each participant was provided with a one-page Key Investor Information
Document of one fictitious structured financial product (discount certificates, bonus
certificates and express certificates) with a description of its functionality. As with
actual issuer prospectuses, these documents contained scenarios to illustrate the
profitability of the product with respect to the development of the underlying[4]. These
scenarios varied in terms of “suggested return” and “suggested risk”, defined as the
arithmetic mean of product return and variance within the scenarios. The participants
were asked for their estimation of product return and risk. The author was interested in
whether these scenarios impact investor judgment or not (Task 7). The cognitive actions
related to not being influenced by these possibly biased scenarios are understanding
that the scenarios are fictitious and do not represent an indication on the part of the bank
(regarding the performance of a product) and thus not giving weight to these scenarios
when judging profitability of a product. According to the anchor heuristic and
availability heuristic (Tversky and Kahneman, 1974), investors’ estimation of product
return and risk should be influenced by these scenarios. However, the authors ran a
battery of models and robustness checks and conclude that investors are hardly affected
by biased (economically irrelevant) scenarios.
The next task deals with the development of a sound understanding of the product
when investing in retail derivatives. As the complexity of retail derivatives can become
quite high (as indicated in Section 3), it seems relevant to thoroughly understand the
nature and complexities of a product before making an investment decision. Entrop et al.
(2014b) investigate the performance of individual investors investing in discount
certificates and bonus certificates (Task 8). The underlying of their analyzed products
comprises a broad range of stocks and the analyzed trading period lies between 2004
and 2008. The cognitive actions investigated in this study are developing a comparable
 QRFM understanding of discount and bonus certificates, understanding payoff structures of
8,1 more complex products and understanding the path-dependent capital protection of
bonus certificates. The authors show that individual investors exhibit a negative risk
adjusted return (even before transaction costs) for discount certificates. However, this
return is even more negative for bonus certificates. Annual returns on investments in
discount certificates amount to ⫺3 per cent and fall as low as ⫺10 per cent for more
54 complex bonus certificates. One explanation for this finding is that the increased payout
complexity of bonus certificates in comparison to more easily understood discount
certificates puts a too high cognitive load on the reasoning abilities of individual
investors[5].
Task 9 analyzes whether investors are able to learn from their past trading
experience. Bradbury et al. (2014) question whether an increase in experience leads to a
better understanding of products and hence to more rational investment decisions based
on a more sensitive perception of the risk-return-profile of the certificates. The authors
simulate trading experience by showing random samples of a previously described
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return distribution to their 105 participants in the base experiment. The related
cognitive actions are learning from trading experience to better understand the
relationship between risk and return and drawing appropriate conclusions for future
investment behavior. The authors find that simulated experience indeed leads to a better
understanding of the product’s risk-return-profile and prompts investors to reconsider
their investment decision. Hence, they are able to draw conclusions and to learn from
their investment experience.
Task 10 deals with the conjunction fallacy. In an experimental study, Rieger (2012)
examined to what extent individual investors (more than 40 test subjects) are able to
give adequate probability estimates. According to the conjunction fallacy (Tversky and
Kahneman, 1982, 1983), people tend to estimate the probability of two (or more)
independent events occurring simultaneously as higher than the probability of only one
of these events occurring alone:

Probability (A and B) ⬎ Probability (B)

The cognitive action related to not falling prey to the conjunction fallacy is to
understand and be able to draw inferences from stochastic relationships. Rieger
investigated two different worst-of-products with three (Product 1) or one (Product 2)
comparable underlying value(s). Thus, the development of these products depends on
whether at least one of the underlying values falls below a certain threshold (Rieger,
2012, p. 114). Participants estimated the probability that at least one of the three
underlying values of Product 1 falls below the threshold to be lower than the probability
that the one underlying of Product 2 falls below this same threshold. Transferred to the
conjunction fallacy, these events represent the possibility that the barrier of the products
has never been hit at any time before or at maturity. Thus, participants fell prey to the
conjunction fallacy which most likely results from cognitive limitations.
To recapitulate, we conducted an as comprehensive as possible review of as many
tasks analyzed on this market as possible. This short review reveals that while
individual investors are able to perform a certain number of tasks, they are unable to
accomplish others. They are able to invest with sensitivity to prices (Task 1), follow
news passively (Task 4), search for news actively (Task 5), conduct feedback-trading
 strategies (Task 6), resist persuasion attempts by banks in scenarios (Task 7) and to Dumb noise
learn from their trading experience (Task 9). On the other hand, they are neither able to traders?
determine product margins (Task 2) nor issuer default risk (Task 3), they do not develop
a sound product understanding for more complex products (Task 8) and fall prey to the
conjunction fallacy (Task 10).

5. Survey on mental demand 55

To fairly judge the cognitive competence of individual investors on the market for retail
derivatives, the reasoning ability demanded to perform the tasks described above needs
to be assessed. We therefore conducted a survey among three groups of experts in the
field of finance:
(1) all authors of the abovementioned studies;
(2) professors and lecturers in the field of (behavioral) finance from 60 different
German universities and universities of applied sciences; and
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(3) experienced practitioners working at Boerse Stuttgart, which is the largest

secondary market for retail derivatives in Germany.

In total, 13 authors of the reviewed studies, 15 other financial researchers and 22

practitioners out of about 130 polled experts participated in our survey. On average, our
surveyed experts (65 per cent male; 35 per cent female) are 39 years old and have 15
years of relevant research working experience. Finally, we only considered experts with
at least 3 years of relevant research working experience.
Initially, all participants were introduced to the purpose of the survey and were given
a short description of verbal and mathematical reasoning ability. The experts were, in
turn, asked to estimate the demand that each of the tasks imposes on the verbal and
mathematical reasoning abilities of the investors[6].
First, the participants were asked to estimate the cognitive competence and
investment performance of retail investors relative to institutional investors on a scale
from 1 (much lower) to 7 (much higher). With a mean of approximately 2.6 for both
estimates, experts perceive retail investors to be both: cognitively less competent and
less skillful (to a comparable degree). None of the experts estimated the cognitive
competence or investment competence of individual investors to be higher than that of
institutional investors. This underscores the widespread perception of retail investors
as dumb noise traders.
In the next step, we asked for the expert’s estimation of the complexity of the
certificates introduced in Section 3 (again on a scale from 1 (very low) to 7 (very high)).
For this, the arrangement of products in the survey was randomized. Table I illustrates
the products in ascending order according to the mean complexity estimated by the
experts.
It is important to note that the here analyzed product types account for about 70 per
cent of total market turnover in Germany (DDV, 2015). The remaining turnover is
mainly achieved by factor certificates which are very closely related to warrants and
index certificates whose payoff complexity is comparable to stocks. Our analyzed
products are thus not only the products given most attention to in the literature, but also
the most frequently traded ones.
It becomes obvious that warrants, discounts and capital protection products are
considered to exhibit the lowest product complexity. Turbo, bonus and express
 QRFM certificates are seen as somewhat more complex. Turbo certificates cease to exist when
8,1 the underlying hits a certain threshold, bonus certificates offer a conditional capital
protection and the development of express certificates depends on a number of
conditions (see Section 3). These non-trivial features apparently make these products
more complex than certificates comprising elementary option elements only.
Worst-of-products are by far the most complex products analyzed in this study, as they
56 require investors to consider multiple (here: three) underlyings. The last two columns of
the table illustrate how many experts gave their highest/lowest assessment to the
respective product. These findings support the argumentation of Entrop et al. (2014b) or
Célérier and Vallée (2014) concerning product complexity. However, in contrast to these
and other studies, we do not simply order products, e.g. according to our own subjective
assessment, but rather on the basis of the assessments of many experts (based upon the
notion that wisdom lies in many counselors). This assessment can be seen as a first
general contribution for future research in this area (Table II).
Subsequently, we presented descriptions of all tasks discussed in Section 4 to the
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experts in a randomized order. We asked the experts for their estimation of the verbal
and mathematical reasoning demands associated with each task (on a scale from 1 to 7).
Additionally, we asked for the expert’s opinions on the relevance of the respective task
for trading success/performance (again, on a scale ranging from 1 to 7).
We ordered the tasks according to “tasks successfully accomplished” and “tasks not
successfully accomplished” (task feasibility) and overall mental demand (average of
mathematical and verbal reasoning demand). It becomes obvious that, by trend,
mentally more demanding tasks are those which individual investors are not able to
accomplish according to the findings of the reviewed studies[7]. Kendall’s coefficient of
concordance (a normalization of the Friedman test which lies between 0 and 1, see
Kendall and Smith, 1939) comes to about 0.38 for overall mental demand which we
interpret as a fair to mediocre degree of agreement among experts. Considering the three
sub-groups of our sample separately:
(1) this value rises to about 0.45 for the authors of the analyzed studies;
(2) achieves 0.51 for all other researchers; and
(3) drops to about 0.15 for non-researchers.

Product Mean Median SD Minimum Maximum

Discounts 3.72 4.0 1.22 19 4

Warrants 3.78 3.0 1.68 24 9
Capital protection 3.92 4.0 1.64 18 7
Turbo 4.70 5.0 1.51 9 16
Table I. Express 4.73 5.0 1.34 7 9
Assessment of the Bonus 4.95 5.0 1.29 6 10
cognitive complexity Worst-of-products with three underlyings 5.58 6.0 1.47 6 36
of the retail
derivatives analyzed Notes: The table illustrates the mean and median of the produt’s complexity (on a scale from 1 to 7)
in the reviewed and the standard deviations. Additionally, the number of times the respective product is the lowest
studies based on the ranking product of expert i (min) and the number of times it is the highest ranking product (max) is
results of 50 expert provided (multiple products can be the highest- or lowest-ranked products of expert i when they were
opinions assigned the same score)
 Downloaded by 27.34.20.38 At 18:02 12 March 2018 (PT)

Overall Relevance to
Task Product mental Math Verbal performance

Tasks performed successfully

Investing with price sensitivity (Task 1) Warrants
Mean 3.28 3.54 3.02 4.44
SD 1.44 1.65 1.55 1.54
Median 3.0 3.0 3.0 5.0
Minimum 22 16 27 8
Maximum 4 5 2 13
Feedback trading (Task 6) Warrants
Mean 3.56 3.88 3.24 3.46
SD 0.95 1.33 1.36 1.40
Median 3.5 4.0 3.0 3.0
Minimum 14 8 22 20
Maximum 1 8 3 4
Monitoring company-specific news passively (Task 4) Turbos
Mean 3.65 2.80 4.50 3.56
SD 1.06 1.37 1.28 1.50
Median 3.5 3.0 5.0 3.0
Minimum 12 28 5 22
Maximum 2 2 12 4
Monitoring company-specific news actively (Task 5) Turbos
Mean 4.00 2.98 5.02 4.44
SD 1.10 1.34 1.42 1.44
Median 4.0 3.0 5.0 4.0
Minimum 7 24 4 9
Maximum 4 1 26 11
Learning from trading experience (Task 9) Capital protection
Mean 4.28 4.22 4.34 5.50
(continued)

Table II.
57

of the 50 experts
Dumb noise

on the assessments
analyzed tasks based
relevance of the
Mental demands and
Survey results:
traders?
 Downloaded by 27.34.20.38 At 18:02 12 March 2018 (PT)

8,1

58
QRFM

Table II.
Overall Relevance to
Task Product mental Math Verbal performance

SD 1.08 1.28 1.29 1.36

Median 4.5 3.0 4.5 6.0
Minimum 6 4 10 2
Maximum 6 5 9 27
Persuasibility (Task 7) Express
Mean 4.35 4.06 4.64 4.48
SD 1.09 1.41 1.17 1.47
Median 4.5 4.0 5.0 5.0
Minimum 3 5 3 6
Maximum 4 5 16 7
Average mean 3.85 3.58 4.12 4.31
Average SD 1.11 1.39 1.36 1.44
Average median 3.83 3.50 4.25 4.33
Tasks not performed successfully
Considering issuer default risk (Task 3) Discounts
Mean 4.24 4.34 4.14 4.12
SD 1.18 1.74 1.52 1.51
Median 4.5 5.0 4.0 4.0
Minimum 8 11 6 14
Maximum 4 7 5 14
Investing with margin sensitivity (Task 2) Warrants
Mean 4.70 5.44 3.96 4.72
SD 1.15 1.32 1.56 1.51
Median 5.0 5.5 4.0 5.0
Minimum 1 0 6 6
Maximum 14 26 9 15
Developing a pronounced understanding of more complex products (Task 8) Discounts vs Bonus
Mean 4.99 5.32 4.66 4.94
SD 0.81 0.91 1.15 1.21
(continued)
 Downloaded by 27.34.20.38 At 18:02 12 March 2018 (PT)

Overall Relevance to
Task Product mental Math Verbal performance

Median 5.0 5.0 5.0 5.0

Minimum 0 1 1 2
Maximum 17 15 18 12
Avoiding the conjunction fallacy (Task 10) Worst-of-products
Mean 5.34 5.66 5.02 5.00
SD 0.92 1.13 1.49 1.11
Median 5.0 6.0 4.0 5.0
Minimum 2 0 8 4
Maximum 19 28 13 14
Average mean 4.72 5.19 4.25 4.70
Average SD 1.01 1.28 1.35 1.37
Average median 4.88 5.50 4.50 4.75
p-value t-test mean between groups 0.00 0.00 0.39 0.19
p-value KW-test mean between groups 0.03 0.01 0.83 0.28
p-value t-test median between groups 0.01 0.00 0.50 0.27
p-value KW-test median between groups 0.01 0.01 0.73 0.59

Notes: Overall mental demand is the simple arithmetic mean of verbal and mathematical reasoning demand. Besides the standard deviations, the number
of times the respective task is the lowest ranking task of expert i (min) and the number of times it is the highest ranking task (max) is provided (multiple task
can be the highest or lowest ranked task of expert i when they were assigned the same score). The two groups for the (one-sided) t-tests and the
Kruskal–Wallis tests are task feasibility (accomplishable/not accomplishable)

Table II.
59
traders?
Dumb noise
 QRFM This indicates substantially less agreement among the surveyed practitioners.
8,1 The ranking of tasks according to their cognitive demand is our next contribution to
the current research. It becomes obvious that investors are able to perform tasks with an
average verbal reasoning demand of about 4.1 and an average mathematical reasoning
demand of about 3.6 (out of 7, ordinally scaled). They are thus clearly able to perform
reasoning activities of a somewhat higher order and are not simply dumb but rather
60 exhibit a non-negligible cognitive competence. Additionally, we use one-sided t-tests
and distribution-free Kruskal–Wallis tests to test the null hypothesis that the means and
medians of estimated overall mental demand are equal between accomplishable and not
accomplishable tasks (task feasibility). The results of all tests are highly significant.
Thus, overall mental demand is significantly higher for tasks not accomplished
successfully. Analyzing mental demand in more depth by differentiating between
demand for mathematical and verbal reasoning, it becomes obvious that the null is
rejected for mathematical reasoning demands only, but not for verbal reasoning
demands. In fact, the means of verbal reasoning demands are approximately the same
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for both groups (in both cases slightly above 4). These findings suggest that whether
investors can accomplish a task or not depends on the mathematical reasoning demands
associated with the task, not its verbal reasoning demands. This structure is also
illustrated graphically in Figure 1. Running the same tests again separately for the three
subsets, i.e. authors of the reviewed studies, other researchers and practitioners, does
not alter any of our main findings.
Analyzing our result in more depth, we calculate Spearman and Kendall rank
correlation coefficients between the mean and median of the expert’s assessments of
mathematical and verbal reasoning demands and task feasibility (a dummy variable
taking the value 1 if a task was performed successfully and 0 otherwise). This
correlation amounts to almost ⫺0.90 (Kendall: ⫺0.73) for mathematical reasoning
demand and is highly significant at the 1 per cent significance level for both tests (all
correlations are reported in Table III). Both Spearman’s and Kendall’s rank correlations
between verbal reasoning demand and task feasibility are insignificant and close to 0.
Thus, mathematical reasoning is highly correlated with task feasibility, whereas verbal
reasoning demand hardly seems to play any role at all.
Regarding our next research question, we calculate Spearman and Kendall rank
correlation coefficients between the mean of mathematical reasoning demand of a task
and the mean relevance of the task to performance (Table III). This correlation amounts
to approximately ⫹0.65 (Kendall: ⫹0.49) and is significant at the 5 per cent level. On the
other hand, both Spearman and Kendall rank correlations between a task’s verbal
demands and its relevance to performance are again close to zero and insignificant.
Thus, mathematical reasoning demand is (marginally) significantly correlated with
performance, while verbal reasoning demand is not. Additionally, we calculate all
Spearman and Kendall correlation coefficients for the expert’s median assessments and
obtain similar results. However, the link between mathematical reasoning demand and
relevance to performance becomes insignificant and less substantial.
Summing up, we ordered the analyzed tasks (and the investigated products)
according to their complexity based on the estimations of 50 experts (i.e.13 authors of the
reviewed studies, 15 other researchers and 22 practitioners). We showed that investors
can indeed accomplish tasks with an equitable mental reasoning demand (especially:
verbal reasoning demand). However, mathematical reasoning demand seems to
 Dumb noise
traders?

61
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Figure 1.
Mean assessment of
mathematical (top
figure) and verbal
(bottom figure)
reasoning demand
per task

discriminate between task feasibility. Mathematical reasoning demand correlates

highly with task feasibility and there seems to be a link between mathematical
reasoning demand and task relevance. Contrary to that, verbal reasoning demand does
not correlate with either task feasibility or relevance to success. We thus conclude that
individual investors are not “dumb”; their cognitive competence merely restricts them to
solving the tasks less relevant to successful performance (namely, verbally demanding
tasks).
 QRFM Correlation coefficients Math Verbal Relevance to performance Feasibility
8,1
Panel A: Mean; Spearman
Math 1.0
Verbal ⫺0.14 1.0
Relevance to performance ⫹0.65** ⫹0.25 1.0
62 Feasibility ⫺0.85*** ⫹0.07 ⫺0.36 1.0
Panel B: Median; Spearman
Math 1.0
Verbal ⫹0.06 1.0
Relevance to performance ⫹0.35 ⫹0.02 1.0
Feasibility ⫺0.87*** ⫹0.11 1.0
Panel C: Mean; Kendall
Math 1.0
Verbal ⫺0.07
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Relevance to performance ⫹0.49** ⫹0.18 1.0

Feasibility ⫺0.73*** ⫹0.06 ⫺0.31 1.0
Table III.
Spearman and Panel D: Median; Kendall
Kendall rank Math 1.0
correlation Verbal ⫺0.19 1.0
coefficients for the Relevance to performance ⫹0.28 ⫹0.03 1.0
expert’s mean and Feasibility ⫺0.80*** ⫹0.10 ⫺0.18 1.0
median assessments
of mathematical, Notes: Spearman and Kendall rank correlation coefficients for the expert’s mean (Panel A and C) and
verbal reasoning median (Panel B and D) assessments of mathematical reasoning demand, verbal reasoning demand,
demand, relevance to relevance to performance and the empirical results regarding whether a task could be performed
performance and successfully or not (task feasibility, see Chapter 4). Significance at the 10% level is denoted by *, at the
task feasibility 5% level by ** and at the 1% level by *** a

These findings are highly germane to future regulatory measures. Investor literacy with
respect to mathematical reasoning abilities is comparably low. Thus, future regulatory
measures aiming to protect individual investors should most strongly concentrate on
verbal demonstrations or explanations and abdicate mathematically demanding ones.
On the one hand, one possible measure could be to illustrate risk and return
characteristics in analogy to a six-sided dice, as proposed by Rieger (2009) to circumvent
presenting formulas. On the other hand, our findings strengthen the call for more
mathematical education for investors, as this seems to be both scarce and relevant.
This could be achieved by raising investor awareness for the results of the reviewed
studies and our overarching interpretation of the results of our survey. Moreover, providers
of online trading systems (e.g. EUWAX) could be compelled to ensure an adequate
understanding of the market and its products by the investors. This could be achieved by
offering suitable (online) trainings before they are allowed to trade. Online math trainings
have been evaluated for different target groups (Al-Omari, 2009; Hodges, 2008) and have
been found to be as effective as traditional face-to-face teaching methods (Frederickson et al.,
2005; Karr et al., 2003). Thus, it seems feasible to develop an online course which teaches
potential investors the mathematical skills required for successful trading.
 Our study has two non-trivial limitations. First, our indirect measurement of mental Dumb noise
requirements does not allow us to make definite statements about the cognitive traders?
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 our knowledge. We therefore
think that our approach is a valuable first step toward understanding investors’ 63
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 our
tests and restricts us from using more profound (deductive) statistical analyses.

6. Conclusion
The present work reviews earlier study results dealing with the investment behavior of
individual investors on the market for retail derivatives from a cognitive perspective.
We rank these tasks according to the mental ability they demand, as estimated by 50
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experts. In doing so, we provide an overarching framework of interpretation for these

studies. We question the undifferentiated model-theoretical treatment of individual
investors as dumb noise traders and conclude that individual investors are able to
perform complex cognitive actions. Most strikingly, they are able to perform a higher
order of verbal reasoning actions: they follow news passively, search for
company-specific information actively, prove to be resistant to (potential) persuasive
attempts by banks, compare prizes of similar warrants across issuers, conduct
feedback-trading strategies and learn from trading experience. However, they are not
able to perform tasks requiring a higher degree of mathematical reasoning ability, such
as determining product margins or issuer default risk, they are unable to avoid the
conjunction fallacy or to develop a sound understanding of more complex products.
Our findings suggest that individual investors are not “dumb”; they are merely not
able to solve mathematically more demanding tasks which, however, seem most
relevant to achieve a higher performance. We thus propose to illustrate information in
key investor documents mostly verbally, 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.
Concerning future research, it appears highly fruitful to investigate our findings more
directly by conducting laboratory studies/experiments, as our study can only be considered
as a first step toward understanding the cognitive limitations of individual investors.

Notes
1. See e.g. Barber and Odean (2013) for an overview of irrational stock trading behaviors of
individual investors, and Bauer et al. (2009) or Meyer et al. (2014) for retail derivatives.
2. For more detailed information, see the paper by Rieger (2009, p. 205). If the underlying lies at
or above a specific predetermined threshold (the so called strike price) on one of these due
dates, the certificate is redeemed prematurely and pays back the nominal value plus coupons.
If the underlying trades below this threshold on one of the due dates, the certificate runs
another period. If the certificate still exists at the final due date and the underlying closes
above the strike price, the certificate pays back the nominal value plus coupons. If the
underlying lies below the strike but above another threshold (the so called barrier) at this
 QRFM point of time, the certificate only pays back the nominal value without any coupons. If the
8,1 underlying lies below this barrier, the certificate pays back the value of the underlying only.
3. On the downside, the authors also show that trades driven by active demand for information
do not lead to higher returns.
4. To investigate whether even the simple existence of a scenario has an effect, about one third
64 of all documents did not contain any scenarios at all.
5. According to the results of the study conducted by Döhrer et al. (2013), the margin difference
between these two products is too low to explain this large difference.
6. The full survey including the instructions is omitted for the sake of brevity and is gladly
provided upon request.
7. As we did not present the outcomes of the analyzed studies to our experts, this indicates that
our measure for mental demand based on expert opinions seems to be quite valid.
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Further reading
Blonski, S.C., Bos, E.H., Conradi, H.J., Oldehinkel, A.J. and de Jonge, P. (2016), “Associations
between negative and positive life events and the course of depression: a detailed repeated
assessments study”, Journal of Nervous and Mental Disease, forthcoming.

About the author

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Philip Blonski is from the University of Hagen, Universitätsstraße 41, 58097 Hagen, Germany. Simon
Christian Blonski works as a Psychologist in Hanover, Germany. We thank Benjamin Newell from the
psychology department of the University of New South Wales for valuable comments. This paper is
based on the PhD thesis of Philip Blonski which was supervised by Professor Dr Rainer Baule. We
thank Rainer Baule for very helpful comments on this paper. Philip Blonski is the corresponding
author and can be contacted at: philip.blonski@gmail.com

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