A research report examined the accounts of 66,465 households from 1991 to 1996 in the US. So in total, the research looked at a huge number of accounts, and a vast number of trades. The conclusions from each study were virtually identical: trading hurts your wealth.
Terrence Odean found that as a group all amateur investors underperform the market due to higher than necessary trading costs. But the 20% of traders with the highest turnover underperformed the most. In the sample, while the market went up an annualised 17.1% over the period, the average investor/trader with a turnover of 80%pa returned 15.3%, but the 20% with the highest turnover, 283%pa on average, got only 10%pa.
This study was performed with the clients of a discount (non web) brokerage. How would the figures change for the ultra cheap Internet brokers?
According to Odean, not very much. Commissions were an important part of the reason why active traders had the worst performance, but the main bogeyman was the bid/ask spread. In fact Odean believes that traders as a group are now doing even worse than they did in the old discount brokerage days because turnover has increased even more.
Odean offers the following example: The average trade in his sample was roughly $13,000 in size. Trading through a discount broker, an investor might have paid $60 or so in commissions “round-trip,” or $30 for the buy and $30 for the sale. But by Odean’s estimate, the typical investor also lost a full 1% to the bid-ask spread — or $130 on this typical $13,000 purchase.
If this investor switches to an online broker that makes trades for only $10, the “round-trip” cost of the trade falls to only $20 — but the spread still amounts to a loss of $130, for a total transaction cost of $150.
No doubt $150 is cheaper than $190 but it’s only around 21% less, not the 66% that investors might believe that he or she is saving. And even this 21% savings could be swallowed up if investors choose to change their behavior and trade more frequently as a result of the lower commissions.
As a matter of fact, Odean did find a tendency to trade more when traders switched to cheap web brokers. In the second study he examined the trading records of 1,600 traders that switched from discount telephone trading to deep discount web trading. He found that turnover increased by a third and traders doubled their exposure to “speculative” stocks. That is to say that telephone traders were twice as likely as web traders to buy large stocks, compared to web traders that on average concentrated more on small speculative stocks trading on the NASDAQ and other minor exchanges.
The most interesting finding of Odean’s research is that traders underperform as a group even after taking out trading costs. On average, the stocks these traders sold outperformed the market, and those they bought underperformed the market. One year after each trade, the average investor wound up more than 9% poorer than if had he done nothing. Two years later, the results were even worse.
Odean found that if the traders had not turned over their portfolios, they would have done much better. In fact as a group they tended to buy small company and value stocks, which at the time were a profitable sector. The stocks they picked on average did in fact outperform the market, but traders snatched defeat from the jaws of victory by systematically selling their best stocks early and holding their worst stocks too long.
Why were traders doing so badly? Odean believes there are several reasons. First, most of the traders were buying stocks that had either risen or fallen substantially in the six months prior to buying. Since there are too many stocks to follow, most traders jump into ones that catch their eye due to their sharp moves or media attention. Momentum traders jump in on the biggest gainers and bargain hunters pile in on troubled issues. In both cases they are dealing in a relatively small number of issues in the public eye, and following a crowd is rarely a successful trading strategy.
Another finding was that the traders in the group had a strong tendency to sell the wrong stocks. Odean says traders “strongly prefer to sell their winning investments and hold on to their losing investments, even though the winning investments they sell subsequently outperform the losers they continue to hold.” Selling a loser amounts to admitting you have made a mistake. Traders hate that, they much prefer to sell stocks at a profit, which makes them feel like a winner, as a result traders systematically weeded out good stocks from their portfolios and retained poor ones.
Odean later repeated this research with a substantially larger sample size.
Odean’s later study confirmed a strong correlation between the amount of trading investors did and their returns. Hyperactive traders, with an average of 1,000% annual turnover, had just a 11.4% annualized return after expenses. The least-active investors barely traded, changing just 2.3% of their holdings annually, yet they managed a market-beating 18.5% annualized return (the S&P 500 Index was up 16.9% annually during the period). Note that these figures do not include the tax penalty paid by heavy traders.
But what if hyperactive traders tended to pick worse stocks, such that their lower performance was due to this, rather than their trading? Not so, according to the study. Had the least-active traders done no trading, their returns would have only been 0.25% better annually, whereas the heavy traders would have done more than seven percentage points better annually.
Not surprisingly, Barber and Odean concluded, “Our central message is that trading is hazardous to your wealth.”
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