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JUNE 2006 ADVISOR’S EDGE REPORT
Trading Time
Online traders make costly mistakes
BY STEVEN LAMB
When it comes to investing, the
average person is best served with
by a buy-and-hold strategy and
certainly should not embark on a
program of frequent trading and
market timing, according to one
specialist in investor psychology.
“Human beings don’t have an
intuitive grasp of probability,” says
Terrance Odean, professor of
behavioural finance at the Haas
School of Business at University
of California, Berkeley.
Human beings seem to be
hard-wired to recognize patterns,
whether they are valid in the decision-making process or not.
Odean uses the example of two
cavemen going hunting. They are
about to walk around a blind
corner when they here a growl.
The first caveman walks around
the corner and is promptly eaten
by a sabre-toothed cat. The second caveman sees this and
runs away.
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The next day, the surviving
hunter hears a growl around the
same corner. Now, a modern
investor should know that a sample of one is statistically insignificant, and proceed around the corner. But to the caveman in question, recognizing the potential pattern of “growl = cat = being
eaten,” would be key to survival.
On the other hand, recognizing
patterns that were based on randomness, like ascribing success on
a hunt to the fact he was wearing
a rabbit’s foot around his neck,
would have little impact on the
caveman. The rabbit’s foot did
not actually improve his return,
but the cost of his belief is
negligible.
Such willingness to obey random
occurrences has not served investors
as well as it served prehistoric man.
Perhaps best known for his
study of the early days of online
trading, between 1991 and 1995,
Odean was given unprecedented
access to data for 60,000 active
traders. Screening out non-speculative trades and focusing only on
purchases made immediately after
a sale, Odean found the stocks
which the trader purchased underperformed the one they had sold
by an average of 5.07% after the
first year. After two years, underperformance climbed to 8.61%.
Not only did the investments
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underperform, but investors tended
to rack up large tax liabilities. “In
general they tend to sell off their
winners, which is contrary to optimal tax strategy, but makes you
feel good,” he says. Further hampering returns were trading commissions, which may have been low
relative to full-service brokerages,
but quickly added up as investors
traded more frequently.
With findings in hand, Odean
published his research under the
title “Trading is Hazardous to
Your Wealth.” (Online brokerages
have yet to repeat their generous
offer of access to trading data).
In general, people tend to
believe themselves to be above
average in most fields, whether it’s
investing, driving or virtually any
other mundane task, he says. The
problem is overconfident traders
tend to trade more frequently, earn
less and have underdiversified
portfolios with increased volatility.
Online brokerages pander to
this overconfidence through their
advertising, assuring investors that
they really do have what it takes to
be successful traders.
Because there are limits to the
amount of information human
beings can process, the global universe of stocks – never mind the
multitude of bonds, mutual funds
and market-linked notes – overwhelms the investor. To cope with
excess choice, the mind focuses on
those investments which catch the
investor’s attention at a given time.
Unfortunately, what catches our
attention does not necessarily
make for a good investment. Huge
price fluctuations or news coverage
are generally indications that the
market has already processed any
information that would make a
stock a good or bad investment,
yet these are precisely the factors
that drive frequent trading.
Odean notes that trading
volumes drop off in bear markets,
when declining share prices should
probably be enticing investors to
load up on cheap stocks. But online
traders tend to lose their appetites
for purchases and refuse to unload
the dogs in their portfolios. This
demonstrates what Odean calls selfattribution bias. When investors are
ahead, they take the credit, but when
their holdings decline, they blame
external factors – usually that the
market is missing the value of their
declining stocks.
Odean offers the following advice
to his university students: invest for
the long term; buy and hold; diversify; control trading costs; and pay
attention to taxes. Pointedly absent
is advice that students try to beat the
market. “It’s the hardest thing to do
and it’s more likely to lead to
mistakes,” he said.
AER