You Are What You Trade
Have you met Stuart? He’s a redheaded punk with long sideburns who loves to trade. “I don’t want to beat the Market,” says Stuart. “I wanna grab it, sock it in the gut a couple of times, turn it upside down, hold it by the pants and shake it ‘til all those pockets empty out all the spare change.”
Or perhaps you’ve seen the tow truck driver who rescues drivers in broken-down cars because he just likes helping people. He owns his own island. (“Well, technically, it’s a country.”)
Finally, you may have seen the suburban mom who, returning home from jogging with a friend, punches a few keys on her computer, sells a little biotech stock, and announces, “I think I just made about $1,700.” Her deflated friend confesses, “I have mutual funds.”
These people are investors in a fictional world created by ad agencies. A world in which trading is an excellent form of cheap entertainment and going it on your own is the only way to go.
Does frequent trading bring the same sudden riches to real investors that it showers upon their fictional counterparts? To answer this, and related questions, we have analyzed the daily trading records and monthly positions of 88,000 investors at a large discount brokerage. The data span 10 years and over 2 million common stock trades.
The investors in our studies traded too actively, were underdiversified, clung to their losers, and bought the stocks that happened to grab their attention. They were motivated by overconfidence, the desire to avoid regret, and the difficulty of evaluating thousands of investment alternatives.
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 psychologist--as well as laymen. The sizable population of overconfident investors are so sure what they believe is right, that they are more likely to act on their beliefs. The result: hey trade too much.
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 investors, the stocks they buy subsequently underperform the stocks they sell. In our studies, the average shortfall over a one-year horizon is more than two percent. 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 5.5 percent lower than that of the least active investors.
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. While both men and women reduce their returns by trading, men reduce theirs by an additional 1 percent, and single men by an additional 1.4 percent. If 1 percent—compounded year after year—strikes you as an inconsiderable amount, consider the effort you would expend to save 1 percent on a home mortgage.
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.
People hate to sell for a loss. If you sell for a loss, you will always regret the purchase. Furthermore, if your stock later bounces back, you will regret the sale. We find that investors are about one-and-a-half-times more likely to sell any given winning stock than losing stock. This is an ill-considered policy from a tax point of view. Worse yet, most losers don’t bounce back. One year after the sale, the losers investors clung to had underperformed the winners they sold by an average of 3.5 percent.
When it comes to selling, most investors have only a few options to consider—the stocks they currently own. When it comes to buying, there are thousands of stocks (and thousands of mutual funds) from which to choose. This poses a search problem for which human beings are ill equipped. An investor’s ability to make an informed rational choice is bounded by his incapacity to systematically consider each of thousands of options. We believe that most investors limit their search to stocks that have recently caught their attention such as stocks in the news or those experiencing dramatic price moves. For example, in ongoing research we find that individual investors are much more likely to buy than to sell recent big winners and big losers. Clearly investors don’t buy all stocks that catch their attention, but they mostly buy only stocks that catch their attention.
When Stuart turns his boss, Mr. P., onto online trading, he exclaims, “Feel the excitement? You are about to buy a stock online!” How does going online affect most investors? We’ve analyzed trading records for 1,600 investors who switched to online trading. We found that after going online, investors traded one-third more actively and their speculative trading nearly doubled.
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.
Some investors may trade more actively online because they misunderstand transactions costs. Commissions for online trading have dropped dramatically in recent years. Unfortunately, bid-ask spreads have not narrowed to the same extent, nor have investors’ tendencies to make money-losing speculative trades. In our full sample, investors pay an average bid-ask spread of 1 percent. The average size of a sale is $13,700. Suppose an investor sells $13,000 of one stock and spends the proceeds on another. If she pays $30 per trade in commissions for each trade and 1% in spread, her combined costs are about $190 ($30 + $30 + $130). Were she to switch to a broker charging $8 a trade, she might think that her trading cost had dropped 73% (from $60 to $16). But if she considers the spread, she’ll realize they’ve dropped only 23%, from $190 to $146. And if she further considers that the stock she buys is likely to underperform the one she sells by two percent over the next year, then her expected cost of trading—even at the lower commission rate—is $406.
The online environment fosters cognitive biases that lead to overconfidence. One such bias is the illusion of knowledge. Studies show that, as people acquire more information, their confidence in their ability to predict outcomes rises far faster than the accuracy of their predictions. Online investors have access to vast quantities of data. This data may give them a false confidence that they can pick stocks. Unfortunately, data related to a task aren’t always relevant to the task. Suppose you wished to predict the next number to come up on a roulette wheel. You could know all the historical outcomes on that wheel, and a great deal about how, where, and to what specifications the roulette wheel had been manufactured, but you wouldn’t know which number was going to turn up next. Billions of bytes of market data give most investors no more ability to pick individual stocks than to pick numbers on a roulette wheel. Of course some investors will succeed anyway, and they will be certain that they knew all along which stocks would be winners. And those who fail will be certain that they too were right, but unlucky—this time.
The illusion of control may also increase the overconfidence of online investors. People often act as if their personal involvement can favorably influence the outcomes of random events. Just as the gambler feels more in control when he rolls the dice himself, an online investor may feel in control when he executes a trade. But the gambler controls only when the dice roll but not how they land. And the investor controls only when his trade executes, but not its profitability.
Trading advertisements play to hopes and fears. People hope to win the investing sweepstakes; they fear being left behind. Advertisements also appeal to our cognitive biases. Ads such as the one that reads “You’ll make more, because you know more” reinforce the illusion of knowledge. Others promote a false sense of control. One online broker states that online investing is “about control.” And when Stuart fantasizes about grabbing the market with his hands, dangling it upside down, and shaking ‘til the money comes loose, he’s describing a control investors can long for, but never have.
The online brokerage industry will spend hundreds of millions this year to persuade you that active trading is profitable and fun. Though our own budget is somewhat smaller, our message is simple and true. Investing is profitable, but trading is hazardous to your wealth.
Terrance Odean and Brad Barber. This article first appeared in Bloomberg Personal Finance, May 2000.
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