"We have met the enemy and he is us" – Pogo
"The investor's chief problem—and even his worst enemy—is likely to be himself." – Benjamin Graham
About a year ago, Professors Brad Barber and Terrance Odean published a survey of studies1 from around the world (including several of their own) showing the deleterious impact of bad behavior on investors' wealth. To summarize their findings from the conclusion, "They [individual investors] trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by the media and past experience. Individual investors who ignore the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment."
And just what are the consequences of this subpar behavior? Here are a few key takeaways:
- Barber and Odean's study of active Taiwanese investors found that they lagged the market by 3.8% per year. The aggregate trading losses for these individuals amounted to 2.2% of Taiwan's GDP (in the US, this amount would be $332 billion!).
- Their study of the trading records of 78,000 clients at a large discount brokerage firm from 1991 to 1996 found that the average client lagged a market index by 1.5% per year. When adjusted for risk exposure to the factors of market, size, and value, however, the lag increased to 3.7% per year. Furthermore, they established a direct relationship between the level of trading activity and the degree of lagging the market. The most active quintile of traders lagged the least active quintile by 7% per year. The authors attribute about half of the shortfall to trading costs and the other half to faulty stock-picking.
- Using the same dataset, they found that women trade less frequently than men and therefore obtained higher returns. Nevertheless, both men and women lagged the overall market. Overconfidence is the behavioral attribute at the root of this phenomenon, which the authors claim to be more prevalent in men when it comes to stock trading, an area that is culturally perceived to be in the male domain.
- They found that the average investor holds only four stocks at any given time due to their tendency to invest only in companies with which they are highly familiar. This lack of diversification leads to high volatility which is exacerbated by the high correlations among the few stocks held.
One may wonder how many investors manage to beat the market after trading costs and other expenses. According to Bard Barber who was interviewed by Howard Gold of Marketwatch, it is approximately 1%. From this bleak statistic, we can infer that any investor who hopes to become part of the "1%" via his stock-picking or day-trading acumen is best advised to stick to his day job.
1Barber, Brad M. and Odean, Terrance, The Behavior of Individual Investors (September 7, 2011). Available at SSRN: http://ssrn.com/abstract=1872211 or http://dx.doi.org/10.2139/ssrn.1872211