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October 1999
Investor Behavior
By Michael Pretzer
Men Behaving Badly
If your goal is to save your clients from their own worst investing impulses, you have your work cut out for you, says this leading researcher in behavioral finance. Left on their own, people trade too often, hold losers too long, and just generally muck things up. Especially if they're not female
Terrance Odean, who once held a seat on the Pacific Stock Exchange, has made his own personal investment decisions for more than two decades. When he was young and single, Odean speculated boldly. After he married and began to raise a family, he bought and sold more conservatively. And now, Odean hardly trades at all. "I haven't looked at my investments in over a year," he says. "Seriously, I haven't." Odean has come to believe that trading—at least frequent trading—is a dumb idea.
He should know. For the past five or so years, Odean, an associate professor of finance at the University of California at Davis, has sifted through the investment records of a large discount broker. (For reasons of confidentiality, he won't identify the firm.) He has studied the behavior of investors in 78,000 households located across the nation—looking every which way at their purchases and sales of common stock.
In his rummaging, Odean has found that an individual investor typically turns over about 75% of his household's portfolio annually. By buying and selling that much, he almost assuredly decreases his returns. In Odean's sample of households, a 70% turnover earned an average annual net return that was 3.7 percentage points less than an index of NYSE-AMEX-NASDAQ stocks.
The harder an investor tries, the worse he does. For example, when a household's portfolio is turned over more than 200% a year, the annual net return trails the market index by 10.3 percentage points.
"Trading is hazardous to your wealth," Odean says repeatedly. Yet few investors seem to heed his warning. Instead, they keep on selling and buying.
But why? The UC professor has uncovered some answers—and he's digging for more.
Odean didn't plan a career that would have him tracing the habits of investors and probing their psyche. He grew up in White Bear Lake, just east of Minneapolis, and during the early 1970s, attended Minnesota's Carleton College. He intended to major in math or science but switched to creative writing. Then, he was smitten by wanderlust. It became harder for him to go back to school each fall. "I especially didn't want to go back after I spent a summer in Europe," he says. "But I needed to keep my student deferment."
Five months before he was to graduate, Odean dropped out. He decided to see the world, if for no other reason than to fuel his writing. He was pretty sure two or three years would be enough to experience real life, then he'd return to college. But he miscalculated. Seventeen years later, he applied to the University of California at Berkeley to complete his undergraduate work, after which he went on to earn a PhD.
During his hiatus, Odean lived in Germany, New York City, and San Francisco. He drove a cab, worked construction, and performed other temporary work. Eventually, he became a computer programmer at Statpac, a San Francisco company owned by a friend, David Walonick. ("It was my only real job," admits Odean.) In San Francisco, he met and married Martha Wellbaum; Naomi, the first of their three daughters, was born.
One way or another, he figured he could make money in the investment world. He and Walonick thought if they crunched a lot of numbers they'd find a way to beat the market. "We had all the analytical tools at Statpac," explains Odean. "We told ourselves that we could figure out patterns in the market if we looked at enough data. But all the relationships we found were spurious. I realized we had a lot to learn."
Another friend suggested Odean join him in options trading. "I spent a few days on the floor with him," says Odean. "Not for the life of me would I be able to do his job. My friend is tall, loud, and from New Jersey. I'm not as tall. I talk a lot, but I'm not loud. And I like to sit and think things over."
When he applied to Berkeley, Odean anticipated studying psychology. But the university limited the number of transfer students it accepted; if Odean really wanted to be accepted, the admissions office suggested, he ought to declare a major in something less popular than psychology. He chose statistics. "I knew an undergraduate degree in statistics wouldn't do me harm," says Odean.
At Berkeley, Daniel Kahneman, a psychology professor, became Odean's mentor. But when it came time to decide about grad school, Kahneman recommended Odean pursue not psychology, but finance. He argued that the research and job opportunities were far greater in the business world and that if Odean were set on psychology, he could do research that analyzed business decisions from a behavioral science perspective. The practical considerations were appealing, given that his second daughter, Rosalie, had recently been born.
"Kahneman's advice has been the single most important in my life," says Odean. As soon as he was in grad school, Odean started to ask questions about investors' decision-making.
Left to their own devices, investors make costly mistakes when they trade stocks. One, they let go of winners and hold on to losers. Two, though surely unintentionally, they trade down rather than up.
In psychological terms, an investor's tendency to sell profitable stocks instead of unprofitable ones is known as the disposition effect. From personal experience, Odean knows it can grab hold of an investor. "Before I was in graduate school, I traded wildly and foolishly," he says, recalling a painful episode when the put warrants he'd bought at $2.50 went down to 25 cents. "I refused to think about selling them at such a low price."
But does the disposition effect take its toll on investors on a broad scale, Odean wondered. He studied the investment patterns of 10,000 households and found that, indeed, "investors demonstrate a strong preference for realizing winners rather than losers."
Investors don't cling to losers because they feel for the underdog, certainly. They simply don't want to admit their mistakes. They go into denial or "regret avoidance," as Odean likes to call it. By not unloading lousy stocks, a investor avoids the obvious pain associated with selling at a loss as well as the potential pain of seeing a poorly performing stock that he's dumped turn around.
Selling winners wouldn't be so bad, of course, if investors subsequently bought stock that performed equally well or better. At worst, they'd only be out the transaction costs. But according to Odean, investors tend to trade off their fast horses for slower ones.
In one research project, he compared investors' recently sold stocks with those they had newly acquired. To his surprise, he found that "on average the securities they buy underperform those they sell. This is the case even when trading is not apparently motivated by liquidity de-mands, tax-loss selling, portfolio rebalancing, or a move to lower risk securities." In other words, this effect holds sway even when investors seem to be consciously seeking better, or at least comparable, returns.
Using his big household sample, Odean found that on average the sold stocks had outdistanced the purchased stocks by 3.2 percentage points 12 months after the trade and by 3.6 points after 24 months. When Odean winnowed out non-speculative trades—that is, the ones that were made to raise cash, cut taxes, or rebalance a portfolio—the gap became even wider. After 12 months, the sold stocks had outdone the purchased ones by five percentage points; after 24 months, by 8.6.
"It is difficult to reconcile the volume of trading in equity markets with the trading needs of rational investors," writes Odean. "Rational investors make periodic contributions and withdrawals from their investment portfolios, rebalance their portfolios, and trade to minimize their taxes. Those possessed of superior information may trade speculatively, though rational speculative traders generally will not choose to trade with each other. It's unlikely that rational trading accounted for a turnover rate of 76% on the New York Stock Exchange in 1998."
So why do investors behave irrationally? Why do they trade too much? In a word, overconfidence. They believe, as Odean once did, that they can beat the system.
"Most of us take too much credit for our successes," says Odean. "When a trader is successful, he attributes too much of his success to his own ability. Successful traders tend to be good, but not as good as they think they are."
If one overconfident investor is a danger to his portfolio, what is the threat from a room full of them? Odean also has looked at investment clubs, and deems them no bargain. He studied the investments that 166 clubs made over a six-year period. On average, the clubs turned over 65% of their stock each year. They earned an average annual net return of 14.1%, compared to the S& P 500's 18% and the composite index's 17.9%. And like individual investors, when the clubs traded, they traded down. The stocks the clubs bought produced lower returns than the stocks they sold, Odean says.
If togetherness doesn't help in-vestors, what about flying solo on the Internet? "Online investors have access to vast quantities of information, generally manage their own portfolios, and trade at the click of a mouse," says Odean. "These aspects of online trading foster greater overconfidence. And greater overconfidence leads to elevated trading and poor performance."
Odean reviewed the investment patterns of 1,607 individuals who switched from telephone-based trading to online trading between 1991 and 1996. Before making their switch, the investors did quite well. Although they averaged an annual stock turnover of about 70%, they beat the market by more than 2 percentage points. After going online, they accelerated their trading. In the first month after the switch, they reached an annualized 120% turnover. After two years online, their trading subsided somewhat, down to a 90% turnover.
Not only did the online investors trade more frequently, they dealt more speculatively—and less profitably. They underperformed the market at a rate of more than 3 percentage points a year.
Odean also compared the online traders to 1,607 investors with similar portfolios who eschewed the mouse and modem. By any measurement, he concludes, the performance by online in-vestors was worse than that of the telephone-line investors.
Thus far, Odean has found only two factors that work in investors' favor. Experience is one of them. Overconfi-dence—and the resultant hyper-trading—wanes as an investor buys and sells. "Old traders will, on average, have a more realistic self-assessment," says Odean. "They will likely have success records more representative of their ability."
The speed at which an investor gets real depends on the individual—stubborn, foolish, and narrow-minded folks usually take a long time—and the environment. "A trader who receives frequent, immediate, and clear feedback will peak in overconfidence early and quickly realize his true ability," says Odean. "Unfortunately, financial markets are difficult environments for learning, as feedback is often ambiguous and comes well after a decision was made."
The other helpful factor is gender. It's better to be a woman.
Based on the research of several psychologists, Odean theorized that women would be less likely than men to become overconfident from buying and selling stock. Therefore, they would trade less and earn higher returns. He put his theory to the test; he compared the performance of accounts opened by women with accounts opened by men. Lo and behold, he found that women turn over their portfolios about 53% annually and men 77%. And though both genders of investors lost ground during a year of trading—that is, their new stocks yielded an annualized return that was smaller than that of the stocks in their portfolio at the beginning of the year—men fared a percentage point worse. When Odean considered only unmarried investors, who presumably were not influenced for better or worse by a spouse, the performance difference widened to two percentage points.
Perhaps, one might argue, female investors simple have a knack for picking good stocks. No, says Odean. Married and single women and married and single men all have an "inferior" ability to select stocks, he asserts. But men—especially single men—are more likely to forge ahead regardless.
Just don't count Odean among the young and reckless anymore. "Doing research that shows people buy and sell too frequently has taken the fun out of trading," he says. "When I consider selling or buying, I end up saying to myself, ‘This probably isn't as smart as I think it is."
