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Smart Investing
Why investors pay the cost of confidence
16 July 2007
Robin Bowerman
Overconfidence is the arch-enemy of sensible investing. And when markets are bouncing around record highs it is easy to confuse great results with investing brilliance.
This makes a warning from a leading US finance academic in Australia this week all the more timely.
Terrance Odean is Professor of Banking and Finance at the Haas School of Finance at the University of California and he is a leading researcher in the field of behavioural finance – a relatively new field of academic work dedicated to understanding why investors make the decisions they do.
Overconfidence, Odean argues, is a useful trait when facing many of life’s challenges – but not when it comes to things like investing or driving a car.
His original research PhD theory was that overconfident investors would trade more often and earn less. “What happens to the market if the market is full of overconfident investors? Overconfident investors trade more because they think that they're right. They think that their idea is a sure thing, and they are willing to bet on it. As a result, they tend to earn less. They under-diversify because when you're sure you're right, there does not seem to be a need to hedge,” Odean says.
He and fellow academic Brad Barber put his theory to the test by studying two sets of data from an online share broker – more than 60,000 investor accounts in all.
They calculated the net return for each portfolio after commissions and transaction costs and found that active traders underperformed buy and hold investors by about 6 per cent a year. They later subdivided the data again and found that men traded more than women – and suffered in the performance stakes because of it - and the worst offenders of all were single men – who traded 67% more than their single female counterparts.
Odean believes there are some simple mistakes that typical investors make – they trade too much, they hold on to losing investments to avoid the feelings of regret that accompany selling a loss-making investment and they chase the latest news or attention-getting performance when deciding what investments to buy.
He credits at least some of these problems with our evolution as a species from the hunter-gatherer caveman days. We have become proficient at basic maths and accounting but Odean argues that successful investing involves a good understanding of probability – something not intuitive to most of us.
One of the dilemmas Odean sees for investors is that technology makes it so easy to trade not just shares but even more complex (and higher risk) investment products like futures and commodities. He argues that if someone wakes at 3am with a brilliant idea about what to buy or sell it might be better if they could not trade and had to wait until morning. He highlights the danger with a series of TV ads from the US that portray online share trading as the modern, exciting, even sexy way for ordinary people to be in control of their portfolios and make their fortunes.
His research cites the big jump in trading activity when people moved from telephone broking services to online and says these investors were doing well before they went online but the churning of the portfolio meant their net returns went negative. Hence the title to one of his research papers – “Trading is hazardous to your wealth…”
So his simple advice for investors? Buy and hold, diversify, control your trading costs and pay attention to taxes.
More articles from this week's newsletter:
ANZ: will the new CEO sing in tune?
Companies to benefit from the rise of the grey nomads
What is the ideal mix of companies?
Trading: is your bargain stock a lemon?
Investing in a toppy market
Are investment clubs good for your wealth?
Stock of the week: TPI
Inflation: when is 'core' not so core?
CFDs: the best time to trade
Analyst report: gold bull seasonals
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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