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Trading Down

Study Supports Long-Term Approach

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Editor’s note: The following is from a Jan. 4 interview with Terrance Odean, the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley, conducted by Dan Richards, president of Toronto-based Strategic Imperatives. For a free subscription to the Advisor Perspectives newsletter, visit www.advisorperspectives.com/subscribers/subscribe.php.

Let’s talk about the research you and your colleague, Brad Barber, have done digging into the trading behavior of individual investors. We’ve done a lot of studies looking at different aspects of investor experience and what individual investors do. We looked at trading activity and the effect of active trading on people’s returns. The first study I did on this was as part of my dissertation. I was able to obtain trading records for 10,000 investors at a large discount brokerage firm.
The question I asked is if someone sells a stock and then buys another stock, on average does the stock they bought outperform the one they sold by enough to cover their trading costs? Somewhat to my surprise, I found out that, not only do people not cover their trading costs — and I had expected that — but on average the stocks they bought went on to underperform the stocks they just sold. The shortfall was 2 percent to 3 percent over the course of the year, on average.

So that was the first study you did. Where did you go from there? I obtained a second dataset from a large discount brokerage firm. My colleague Brad Barber and I looked at this. We wanted to get at the same issue. Are people trading too much? What is the effect of active trading on the return for average individuals?
We looked at trading records for over 60,000 households. These were self-directed accounts. We put them in five groups based on how actively the portfolios were being traded — the turnover rate in the portfolio. We had the virtual buy-and-hold portfolios right on up to the very active traders, and for each group we calculated the average annual net return (after trading costs).
We found that the buy-and-hold investors were, on average, outperforming the active investors by about 6 percent per year. Thus, we titled the paper “Trading Is Hazardous to Your Wealth.”

And where did you take your research from there?  We looked at the same topic one more time, from a little bit of a different angle. I had written a theory paper that said that, due to overconfidence, people are likely to trade more than they should and earn a little less than they would if they hadn’t traded as much. The theory was that overconfidence is one of the things that leads people to trade too much.
An ideal test of that theory was to get a large sample of investors and to somehow separate them into those who tend to be more overconfident and those who tend to be less overconfident. We had data on a large sample of investors, but we didn’t have any way to send out a psychological test of overconfidence to 60,000 investors.
For over 30,000 of those investors we had a lot of demographic data. We looked at the psychology literature and reflected on our own anecdotal observations. We realized that on average, men and women differed in their average degree of overconfidence. What surprised some people — but not my wife — was to find out that men tended to be more overconfident.
We divided our group into men and women. We started with a prediction: Men are going to trade more actively, and this trading will hurt their returns. That’s exactly what we found.
Men traded 67 percent more actively than women in our sample. When we looked at the effect of trading on people’s returns — what people earned versus what they would have earned if they had taken a buy-and-hold approach. Men and women were both underperforming a buy-and-hold approach, but men were underperforming by an additional 1 percent a year. This is consistent with the idea that overconfidence can lead you to trade too much and that excessive trading hurts your returns.

What are the key conclusions that an individual investor should take away from your research?

What are the one or two takeaways? The advice I give is pretty much the advice I think you get from most, if not all, financial advisers. Generally speaking, you should buy and hold, invest for a long horizon, pay attention to your trading costs and taxes, and diversify.

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