Overconfidence and Excessive Trading Harm Investor Returns

Terrance Odean is the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley, where he chairs the Haas Finance Group.  He is known for his work on behavioral finance.

Dan Richards interviewed Professor Odean on January 4 at the annual meeting of the American Economic Association in Atlanta, GA. This interview is one of a series that Dan conducted at that conference, and we will provide links to videos of his other interviews. Dan is president of Toronto-based Strategic Imperatives.

How exactly do you define behavioral finance?

Behavioral finance is basically the same as classical finance with the added twist that you take into consideration that people are not always rational with respect to money.  These departures from rationality can make a difference – to behavior and to welfare, particularly for individual investors.  A lot of us believe that they make a difference in markets.  Markets do not behave as smoothly as they would if everyone were always rational.

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 2-3% over the course of the year, on average.

People were not doing well.  They were clearly trading too much.

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% per year.  Thus, we titled the paper, “Trading is Hazardous to your Wealth.”