Wealth Warning for Stock Pickers

Stock pickers are inherently biased about their abilities to pick winning stocks. In a study titled, "Are Investors Reluctant to Realize Their Losses?,"1 Terrance Odean, professor of finance at the University of California, Berkeley, analyzed the activity of 10,000 discount brokerage accounts. Odean's findings, published in the October 1998 issue of Journal of Finance, showed that investors habitually overestimated the profit potential of their stock trades. In fact, they would often engage in costly trading, even though their profits did not cover even their transaction costs. Odean's research showed investors believed they had unique information which would give them an edge, when in reality they operated under widely disseminated information. On average, the stocks investors bought underperformed the stocks they sold.

In a follow-up paper, "Trading is Hazardous to Your Wealth: The Common Investment Performance of Individual Investors,"2 Odean joined Brad Barber of University of California, Davis to analyze 66,465 individual trading accounts. They found that from 1991 to 1996, investors who traded most earned annualized returns of 11.4%, while in the same period the market earned annualized returns of 17.9%. Excessive trading resulted in inferior returns compared to the market.

    -1 Terrance Odean, "Are Investors Reluctant to Realize Their Losses?," The Journal of Finance, vol. 53, no. 5 (1998).
    -2 Brad M. Barber and Terrance Odean, "Trading is Hazardous to Your Wealth: The Common Investment Performance of Individual Investors," The Journal of Finance, vol. 55, no. 2 (2000).
Step 3Stock Pickers