menu › Investor Solutions | Good Move | Call Now: 1.800.508.8500 | Your goals. Your needs. Our mission
phone 1.800.508.8500
Knowledge Center

share this article download pdfprint

Hazardous To Your Wealth

By: Frank Armstrong

By: Investor Solutions, Inc.

Benjamin Graham was right: Investors are their own worst enemies.

It’s no great secret that investors generally achieve disappointing investment results. In an efficient market, the dumbest investor we know–or a reasonably talented monkey–should be able to select a random sample of stocks that pretty well tracks the market. Evidently investors aren’t the rational critters that this theory suggests they are. Behavioral finance examines how what investors actually do influences the result that they get.

A working paper, Trading is Hazardous to your Wealth: The Common Stock Investment Performance of Individual Investors, examines the trading activity of 66,465 household accounts from 1991 to 1996 at a major discount brokerage. (The paper is scheduled for future publication in the prestigious Journal of Finance.) The study observes trading patterns, compares results, and attempts to find a psychological reason for investor behavior.

The paper’s authors, Brad Barber and Terrance Odean, both of University of California’s Davis School of Management (Finance), explore how three behaviors–overconfidence, regret avoidance, and attention–contribute to investors’ underperformance.

Overconfidence

Overconfidence manifests itself in several ways. Sometimes people take too much credit for their success, confusing a bull market with stock-picking brilliance. Or they overestimate the precision of their knowledge. Several years ago, a large insurance company found that among their own employees that rated themselves as very sophisticated in financial matters, the majority thought that money market funds held common stock. Or investors choose inappropriate benchmarks. If they held a stock that doubled they’d be satisfied, even if the market had tripled over that same time.

Confidence and even overconfidence are necessary survival mechanisms, and healthy in most cases. After all, you wouldn’t want to fly with an airline captain that had doubts about his or her ability to land the plane. Not much good would get done if people consistently believed that they would fail.

But overconfident investors can fall into self-destructive behaviors. In particular, they trade too much. That hurts their performance. “Overconfidence gives the investor the courage of their misguided convictions,” says Barber. Each trade make up the market. Because these other traders are also skilled, knowledgeable, and have real-time access to sophisticated data and forecasting information, beating the market consistently is extraordinarily difficult to do. There is no rational reason for investors to believe that they can. Yet they trade in an attempt to do just that.

Further, trading drives up costs that include commissions, bid-ask spreads, and market impact–not to mention paying taxes on any gains, which weren’t included in the study. There’s a direct relationship between how often investors trade and by how much they under-perform their benchmarks.

Regret Avoidance

Regret avoidance drives investors to hold losers and sell winners. Investors hate to sell losers, and understandably so: Selling a loser means confronting a failure that the investor may not care to recognize. It feels so much better to sell a winner; that’s only confirming a good purchase.

Barber and Odean found that regret avoidance behavior dominates the decision to sell throughout most of the year. It’s not until the fourth quarter that investors sell losers to harvest tax loses. Of course, in an efficient market, both winners and losers are correctly priced, and substitution of one for another should have no effect beyond transaction costs. So while regret avoidance may be curious behavior, it doesn’t explain underperformance by itself.

Attention (or Chasing the Action)

Barber and Odean found that the investors in their study purchased stocks that performed worse than the stocks they sold. The investors are therefore underperforming their own benchmarks–the portfolios that they started with. The study documents that difference in performance between stocks sold and stocks purchased (excluding trades for non speculative reasons) was minus 5.07%, on average, one year later and minus 8.61% two years later. That’s right: The stocks that are sold do much better, on average, than the stocks that replace them.

How’d that happen? Simply put, investors love to chase the action. Sure, there are thousands of stocks to pick from, but with limited time, resources, and processing ability, investors are drawn to a small subset of stocks that catch their attention–which often means stocks that experience extreme price movement, either up or down.

This attention drove the buy side of the trade decision. The individual investors in the sample loaded up heavily on these extreme-performing stocks. Maybe they believed that a sharp jump in stock price signaled “momentum,” and a plunge in price signaled an “overreaction” by other investors. Unfortunately, extreme performers as a group also lag the market seriously for one to two years. Chasing the action just doesn’t pay.

Remember Barber and Odeon’s findings next time you are tempted to log on for a little day trading. Click here to read their working paper, and let me know what you think.