The ‘average investor’ has 10 ways they trip themselves up. Do you show any of these tendencies? 

Think you have an idea about what the “average investor” might be? You may well be surprised to know they have 3 major attributes: they are overconfident, they are short sighted and they pretty likely to buy shares at the worst time. What they don’t possess is the ability to think long term and be disciplined in their financial approach.

Generally, a complete lack of understanding of the inherent disadvantages of investing is at the root of the typical investor’s problems. 

But these are not some assumed characteristics: they are the result of 3 decades of study by Terrance Odean, a finance professor at the University of California’s Berkeley’s Haas School of Business in the USA.

Prof. Odean has a PhD in finance and has intently studied investor behaviour. This area of growing interest includes elements of psychology and neurology, as well as economics.

While classic economics describes individual investors as “rational” and able to maximise profit, Prof. Odean’s research has flipped this on its head — to the point, he says, that individual investors are “their own worst enemies”.

Prof. Odean describes himself as his own best lab experiment, pretty much doing everything incorrectly before he studied finance. For example: after a “hot tip” from his broker and “two seconds of research”, he would trade individual stocks using his own brokerage account. When those stocks sank, pride forced him to hold on.

Here are Prof. Odean’s 10 ways to avoid sabotaging your investments:  

1. Don’t trade frequently (it doesn’t get you ahead)
2. Don’t buy on the news (stocks under-perform the market 1.6 percentage points the month after they’re in the news)
3. Avoid trying to time the market (stocks that investors sell generally outperform those they keep)
4. Ditch the pride, and admit being wrong (pride forces investors to keep losing stocks despite the tax benefits of selling them)
5. Understand fund fees
6. Easy trading isn’t smart trading (online trading, being easy, can allow investors to follow their worst instincts, yet study has shown moving from telephone to online trading can take investors from 2% in front of the market to 3% behind)
7. Avoid investment clubs (60% of all investment clubs under-perform the market; usually because they mostly hold small-cap growth stocks, and turnover 65% of the portfolio annually)
8. Avoid running up costs (they sap your investments)
9. Realise your limitations
10. Don’t be a sheep

Let’s go through a 4-point summary of the above.

A. Overconfidence (more prevalent, in, ahem, males…)

Most people over-rate their abilities — including with investing. This particularly strikes males. But before you get annoyed with that statement, it’s straight from Prof. Odean’s research! (He backs this up with psychological research too.) Odean did some research with another finance professor, Brad Barber (also from the University of California), analysing the 5-year trading patterns (1991-97) of 35,000 households. The report reads, “research demonstrates that, in areas such as finance, men are more overconfident than women”, trading 45% more than women.

That’s exacerbated for singles. Odean and Barber’s research showed the confidence of single men in their ability to outperform the market encouraged them to trade 67% more frequently than single women. And the results for all that trading? The men’s portfolios under-performed the women’s by 1.4% each year. Which leads to the next point….

B. Excessive trading

In their research, Odean and Barber write, “It is difficult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors.” Ouch!

Prof. Odean researched the Taiwan Stock Exchange over 4 years, with Brad Barber, Yi-Tsung Lee and Yu-Jane Liu. In looking at every trade, they found that commissions, taxes and poor buy-and-sell timing lopped $32 billion from individual investors wealth.

Their research found that the aggregate portfolio of individuals suffered “an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2% of Taiwan’s gross domestic product or 2.8% of the total personal income. Virtually all individual trading losses can be traced to their aggressive orders.”

Yet, they found that middlemen and institutions did well. Prof. Odean says these 2 groups have an informational advantage in the stock market over the little person. “In contrast, institutions enjoy an annual performance boost of 1.5 percentage points, and both the aggressive and passive trades of institutions are profitable.”

He says even the individual investor who thinks they have good information on a company are still usually in the dark — unlike the bigger investors.

C. Bright and shiny

Prof. Odean’s research has found that individual investors are far more likely to buy and sell the 10% of stocks mentioned in the news — and ignore the other 90%. “Individual investors are net buyers of attention-grabbing stocks, e.g., stocks in the news, stocks experiencing high abnormal trading volume, and stocks with extreme one-day returns.”

Profs Odean and Barber describe this as the “all that glitters” approach.

However, the problem with buying shares just because they’re popular is that they are usually expensive. It’s far better to choose stocks on value. Such glittery shares are also susceptible to changes in investor sentiment.

Individual investors tend to “go with the crowd” here, but institutions do not. As a further kick, often these in-the-news stocks under-perform the overall market — by 1.6 percentage points.

D. Pride and reluctance

While men trade more the women, both are reluctant to realise losses. In research with Brad Barber, Yi-Tsung Lee and Yu-Jane Liu, Prof. Odean found that pride, or an unwillingness to admit they were wrong, stops most individual investors from selling a losing stock. (But not so the institutions.)

In their research, the quartet quote Leroy Gross, from The Art of Selling Intangibles: How to Make your Million ($) by Investing Other People’s Money: “Investors are also reluctant to accept and realise losses because the very act of doing so proves that their first judgment was wrong. Investors who accept losses can no longer prattle to their loved ones, ‘Honey, it’s only a paper loss. Just wait. It will come back’.”

Instead, individual investors are twice as likely to sell if they are holding that stock for a gain rather than a loss. In fact, 85% of all investors sell winners at a faster rate than losers (although the willingness to sell losers increases after strong market returns).

When he analysed the trades of 10,000 accounts at a discount brokerage (1987-93), Prof. Odean found individual investors sold winning stocks at about twice the rate of losers. Yet, this is “not explained by taxes, rebalancing, or transaction costs” and is “even stronger for less sophisticated investors”. Again, it all comes down to pride and stubbornness.

Even worse, while investors are clocking up capital gains (selling winners, not losers), Prof. Odean’s research found that only about a year after being sold, winning stocks gained an average 3.4 percentage points more than the losing stocks that investors kept.

So how do you stop sabotaging your investments?

Be patient. Don’t be full of bravado with investing — take advice, but pick from whom you take it (for instance, your brother-in-law’s mate may really know more about cricket than the share market). Don’t trade in a frenzy — it’s really only good for the movies. Judge on value, not what’s hot in the news. Pride has no place in investing. And lastly: have a long-term plan.

Sources: Forbes.com Investment Guide; ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, by Brad M. Barber and Terrance Odean, in, “The Quarterly Journal of Economics”, February 2001; “Just How Much Do Individual Investors Lose

by Trading?” by Brad M. Barber, Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean; All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors”, by Brad M. Barber and Terrance Odean; “Is the Aggregate Investor Reluctant to Realise Losses? Evidence from Taiwan”, by Brad M. Barber, Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean.

Tags: Behavourial finance, investment thinking