- Investing is all about finding a balance that works for the long run.
- Loss aversion can lead to underinvestment, but overconfidence can lead to concentrated bets, and as we’ll explore in this post, overtrading.
- According to the research of Barber and Odean, overtrading can cost investors about 7% a year in returns on average.
Granted, there’s plenty of excitement to be gained watching your positions go up and down over time. And of course, you’ll never forget that one big play that netted you enough to buy that first car. But is all this effort productive, or is it just an expensive way to pass one’s time?
It didn’t take Goldilocks too long to figure out that among the three bowls of porridge, the middle one was the one that was the best choice; not too cold, not too warm, just right.
When it comes to investing, an analogous situation arises: one can participate too much, too little, or just enough. However, investing “just enough” for many investors is easier said than done.
It’s clear how participating too little can lead to missed opportunity. Quite simply, if you are never invested, your hard-earned capital will continue to lose purchasing power time, becoming less valuable year after year.
But what’s wrong with investing too much? Or rather too often? As it turns out, being too active with an investment portfolio can lead to chasing returns in the short-run; and over the long-run, this can lead to underperformance. But let’s actually dive into the research on this topic and see for ourselves the impact that this type of behavior can have.
“The stock market is designed to transfer money from the active to the patient.”–Warren Buffett
As I’ve stated in Part 1 of this series, taking on the challenge of managing one’s own portfolio can be a formidable task. Furthermore, in my series, Passive is the New Aggressive we discussed in detail why passive funds have the potential to provide investors with substantially better value than active funds. Nevertheless, only about 30% of assets are in passive funds.
We’ve discussed overconfidence at length in the past a couple of times. We first introduced the concept in our series on Behavioral Finance. In that series, we suggested that overconfident investors tend to hold concentrated (undiversified) positions that increase idiosyncratic risk (i.e., the risk that a single position does poorly).
“The investor’s chief problem—and even his worst enemy—is likely to be himself.” –Benjamin Graham
Another feature of overconfidence is excessive market trading. Of course, the overall point of an active investment strategy is to trade, as compared to a passive investment strategy, where the goal is instead to buy and hold for the long-term. Unfortunately, as we’ll soon see, too much trading can have a strong negative impact on performance.
A Barber for Odean
Brad Barber is the Gallagher Professor of Finance at the UC Davis Graduate School of Management. He is a prolific publisher of research, particularly in the field of Behavioral Finance, and his contributions to our understanding of investment behavior are tremendous. In fact, “Professor Barber has been recognized as one of the most widely cited financial economists in the world (ranking 38th in one citation survey).” As such, we’ll be sure to explore some of his key findings in this series and in others.
A close colleague of Barber is Terrence Odean. Terrance Odean is the Rudd Family Foundation Professor of Finance at Berkeley Haas. The Barber and Odean teamed up towards the end of the twentieth century to push forward the field of behavioral finance in much the same way that Tversky and Kahneman did for Economics in the sixties.
In fact, it was Kahneman that ultimately persuaded Odean to pursue his Ph.D. in finance (rather than in psychology), and it’s this transition that ultimately leads Odean to focus on investor behavior over the course of his graduate studies. Needless to say, the work of Barber and Odean has been incredibly impactful to the field.
The Courage of Misguided Convictions
In 1999, Barber and Odean published a commanding paper which provided significant insight into just how impactful many of the behavioral biases that we’ve discussed thus far can be to the performance of investor returns.
“The Courage of Misguided Convictions” explores the systematic irrationality that we face when investing and the paper summarizes findings that aim to quantify the effects of these biases. The paper’s abstract (presented here in its entirety) does a good job of highlighting the concerns that we aim to uncover.
“The field of modern financial economics assumes that people behave with extreme rationality, but they do not. Furthermore, people’s deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. We highlight two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. We argue that these systematic biases have their origins in human psychology. The tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second.” –Barber and Odean
We’ll dig into the paper’s analysis of excessive trading in this post, as this particular analysis aligns with the notion that having too much free time can be detrimental to one’s financial well being. The results were stunning, to say the least. For their analysis, the researchers categorized investors into five buckets based upon their level of trading activity.
Those that traded the least were in the lowest bucket (representing the bottom 20% of the sample population of investors in terms of trading activity as measured by portfolio turnover). Those that traded the most were in the highest bucket (representing the top 20%). So as it turns out, the bottom 20% (the least active traders) had an average annual return of 18.5% over the period in question, while the top 20% (the most active traders) had an average return of only 11.4% over the same period. (Source: Brad Barber and Terrence Odean (1999) ‘The courage of misguided convictions’ Financial Analysts Journal, November/ December, p. 50.)
That’s an over 7% annual return difference. Mind you, the long-term return that one can expect for the market is around 7%. This means that if this analysis and history were to be our guide then we might expect a passive (buy and hold) strategy to provide investors with a 7% return, but those that are the most active in their trading we would expect to average something close to zero. Yikes.
Overconfidence and emotion are the enemies of a high quality portfolio.–Warren Buffett
In the next part of this series, we’ll consider another paper from this duo. This one is called, “Trading Is Hazardous to Your Wealth”, was published by Barber and Odean in the April 2000 issue of the Journal of Finance. This particular paper included the excessive trading analysis mentioned above, but also, it digs into the performance of the average investor as compared to a benchmark. As you might expect by now, the findings are not pretty for the average investor.
Ultimately, that’s why I call this particular pursuit the world’s most expensive hobby. Indeed, I surmise that active investing is not about making money so much as it’s about satiating other desires similar to gambling. So check out Part 3 for a deeper dive into all this.