Looking at Why Do Investors Trade Too Much?
University of California Professors Brad M. Barber and Terrance Odean published research and findings in a paper entitled Why Do Investors Trade Too Much? What follows are some excerpts:
Overconfidence
Psychologists observe that most people are overconfident; they overestimate the precision of their knowledge and the level of their abilities. If, for example, you ask a group of people to rate their own driving abilities, you will find that most people consider themselves to be above average drivers. Overconfidence afflicts experts — including psychologists — as well as laymen. The overconfident investor is so sure that she is right, that she is more likely to act on her beliefs. The result: she trades too much.
Active Trading: The Real Evidence
Consider an investor making a speculative trade. She isn’t selling to realize a deliberate tax loss or to raise money to pay a debt. She sells one stock and buys another because she thinks the stock she is buying will outperform the one she’s selling. To break even on this trade, the new stock doesn’t need to merely beat the old one. It needs to do so by enough to cover trading costs. Unfortunately for most individual investors, the stocks they buy subsequently underperform the stocks they sell. In our studies of investors at a large discount brokerage in the US, the average shortfall over a one-year horizon is more than two percentage points. If you add in the costs of trading — bid-ask spreads, commissions, and taxes — the shortfall more than doubles.
The more actively investors trade, the less they earn. We divided 66,465 households into five groups on the basis of the level of turnover in their common stock portfolios. The 20 percent of investors who traded most actively earned an average net annual return 7.2 percentage points lower than that of the least active investors .
Overconfidence and Gender
Men tend to be more overconfident than women. The difference emerges most strongly in areas such as finance that are perceived by our society to lie in the male domain. If overconfidence leads to excessive trading, one might then expect men to trade more than women. They do. We find that men trade 45 percent more actively than women. Single men trade 67 percent more actively than single women. Both men and women are lousy traders; men merely trade more frequently. Both men and women reduce their returns by trading, men reduce theirs by an additional 1 percentage point annually, and single men by an additional 1.4 percentage points.
If 1 percentage point — compounded year after year — strikes you as an inconsiderable amount, consider the effort you would expend to save 1 percentage point on a home mortgage. In short, trading is a mistake made by both men and women; men simply make more mistakes than women.
Overconfidence and Diversification
Overconfident investors underdiversify. If you know you are right, what’s the point of hedging your bets? In a typical month, the median investor in our sample held three common stocks. Of course, some achieved diversification by also owning mutual funds, and others may have owned stocks at other brokerages. While overconfidence accounts for some underdiversification, it is likely that many investors simply don’t understand the advantages of holding a diversified portfolio. In 1999, the S&P 500 index returned 21 percent. Eight stocks accounted for half of that gain. At the end of 1999, 230 of the S&P 500 stocks were below their level of two years earlier. An investor who held only three S&P 500 stocks during this period had a 4.1 percent chance of holding at least one of the big eight winners and a 9.6 percent chance of holding only losers. Thus, in the midst of a bull market, an undiversified investor was more than twice as likely to be left at the starting gate as to win the sweepstakes.
We have all heard stories of investors — even friends or family — who have made small (or large) fortunes by buying a hot stock. These stories tempt us to join the stock picking game. After all, we cannot win unless we play. However, there is a dark side to this temptation. Sadly, many investors are lured into poor decisions by the promise of instant riches.
Thousands of investors were day trading during the late 1990s; many lost a small fortune. Equally tragically, many employees at Enron and Worldcom invested too heavily in their company’s stock and stood by helplessly as these companies declared bankruptcy. The retirement savings of many were lost.
Some investors beat the market, some fail to do so. This is not at all surprising. By mere chance, some will win, and some will lose. It is tempting to judge the winners as success stories and the losers as victims of poor judgment. The truth is that both groups exhibited equally poor judgment by failing to diversify. Serendipity is the only distinction that separates the winners and losers.
Internet Investing
When Stuart turns his boss, Mr. P., onto online trading, he exclaims, “Feel the excitement? You are about to buy a stock online!” The internet has led to an explosion of information about stocks and made trading stock easy. Certainly, the diligent investor can use this information to construct a stock portfolio that will beat the market.
How has this changing environment affected investors? The technological advances of the last two decades are clearly beneficial for investors; unfortunately, the information explosion and ease of trading have their downside. We’ve analyzed 1,600 investors who switched to online trading during its infancy. We found that after going online, these investors traded more actively, more speculatively, and less profitably.
These investors earned exceptional returns in the period preceding their online debuts. After going online, they underperformed the market. The underperformance once online appears to be the result of excessive trading. What about the superior performance before going online? When people succeed, they most often give themselves too much credit for the success. Failures, on the other hand, are blamed on others and misfortune. It is likely that these investors attributed the excellent returns they earned before going online to their own investment acumen, rather than to luck. Having discovered their talent for investing, they increased their trading activity, only to suffer the typical fate of active traders.
The same authors also published: Brad M. Barber and Terrance Odean, Boys will be Boys: Gender, Overcofi dence, and Common Stock Investment, Quarterly Journal of Economics, Vol. 116, no. 1, pp. 261-292, February 2001.