Investors Are Often Their Own Worst Enemies

Terrance Odean is the Professor of Finance at the University of California, Berkeley and known for his work on behavioral finance.

This Forbes article covers some of Professor Odean's thinking and summarizes his case that it is the actions of investors themselves that often subtracts meaningfully from long-term returns.

According to Professor Odean, here's a couple (among others) of the greatest sins investors tend to make:

Overconfidence - A tendency to overestimate their own abilities and the likelihood of favorable outcomes.

Excessive trading - The real winner is the middleman.

The following was put together by Forbes:

In Pictures: 10 Ways Investors Sabotage Themselves

In this paper, "Trading Is Hazardous To Your Wealth", Professor Odean and his colleague Professor Brad Barber concluded the following:

"The average household turns over approximately 75 percent of its common stock portfolio annually. The poor performance of the average household can be traced to the costs associated with this high level of trading.

Our most dramatic empirical evidence is provided by the 20 percent of households that trade most often. With average monthly turnover of in excess of 20 percent, these households turn their common stock portfolios over more than twice annually. The gross returns earned by these high-turnover households are unremarkable, and their net returns are anemic. The net returns lag a value-weighted market index by 46 basis points per month (or 5.5 percent annually). After a reasonable accounting for the fact that the average high-turnover household tilts its common stock investments toward small value stocks with high market risk, the underperformance averages 86 basis points per month (or 10.3 percent annually)."

The paper has some useful insights. Excessive trading and the associated frictional costs adversely impacts returns. The above more than suggests that less activity generally wins. It also at least suggests that many (if not most) investors would be better off just buying index funds.*
(And, of course, accumulating shares over time but, most importantly, holding them long-term. Unfortunately, index ETFs are all too easy to trade which seems like an advantage but quickly turns into quite the opposite.)

The paper's focus is instead on the deleterious effects of highly active trading. That less trading leads to superior returns. They think that the excessive trading behavior is at least in part "explained by a simple behavioral bias: People are overconfident, and overconfidence leads to too much trading."

They conclude by saying:

"Active investment strategies will underperform passive investment strategies. Overconfident investors will overestimate the value of their private information, causing them to trade too actively and, consequently, to earn below average returns." 

I certainly agree with this. Buying and owning shares of great businesses long-term can be executed as a relatively passive investment strategy (passive in terms of trading, but lots of work otherwise). I can understand why this isn't addressed in the paper but is worthy of consideration.

In other words, index funds are treated by some as THE passive investment strategy alternative for most investors. Is that really the case?

Clearly, the long-term ownership of shares (extremely low portfolio turnover) can't be lumped together with those who engage primarily in making guesses about near or even intermediate term stock market price action.
(Even if those guesses are highly educated in nature and happen to involve sophisticated methods of gambling and speculation.)

Owning shares of the great durable franchises is an alternative to buying index funds. It does require the right skill set and -- getting back to how overconfidence can damage returns -- a realistic (not imagined or optimistic) assessment of one's capabilities.

"Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose..." - Charlie Munger in a 1998 speech to the Foundation Financial Officers Group

You can't buy individual stocks without knowing how to judge value consistently well and the discipline/patience to ALWAYS buy at a plain discount.

I'll follow up on this.

Adam

Related posts:
Investors Are Often Their Own Worst Enemies, Part II (follow up)
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Index funds were tough to own this past decade plus but that's mostly the result of extreme valuation across many sectors. Stocks in general (though not many individual stocks, of course) were a decade and more ahead of themselves in terms of valuation.
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