If you imagine a trader what image springs to mind? You probably imagine someone who is supremely confident and decisive. They have a deep insight into stocks, such that they know which shares will outperform or underperform. They are continually buying and selling shares as they generate a steady stream of profitable trades. Oh yes, and they're probably male.
In fact, the most successful and profitable investors are the exact opposite.
Trading is Hazardous to Your Wealth
Research shows that investors that trade most infrequently are the ones who perform best. The reason is the effect of fees. Let's consider the rationale behind selling stock A and buying stock B:
- I believe that stock B will perform better than stock A
- The outperformance will more than pay for the fees in selling stock A and buying stock B
The second statement is an important one. You will lose money every time you trade, guaranteed. You will pay a broker fee for both trades, the buying price will be above the selling price (bid-offer spread) and in the UK you will pay Stamp Duty Reserve Tax to buy the new stock. In order to do this you have to be confident in both statements. Unfortunately this confidence is usually unfounded.
A beautiful research study by Brad Barber and Terrance Odean in 2000 presents some powerful evidence that overtrading makes you poorer. In their paper "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors", they tracked 66,465 households in the US from 1991 to 1996. They broke the households into five groups ranked by how much of their portfolio they turned over per month. Here are their results:
This clearly shows that trading made little difference to the gross annual return, which is the return before you subtract fees which was in a tight band in the range 18.5% to 18.7%. In contrast there was a huge difference due to fees which consistently reduced net annual return. Households that traded least held on to the full gross return with a return of 18.5% whereas those that traded most earned just 11.4%.
The group which traded least was the group that made the greatest net return because they paid less in fees.
Turnover for the average household was a staggering 75%. This means that if you compare a portfolio on January 1st and December 31st then three quarters of the portfolio would have changed. Did all this frantic trading pay off? No! It turns out that the average gross return was almost identical to the US technology stock index the Nasdaq. Nowadays it's possible to track the Nasdaq 100 index paying just 0.2% per year in fees. Here are the chunky fees:
- The average "round-trip" trade (buy then sell) had a transaction cost of 1% for bid-ask spread and 3% for commissions.
- Bid-ask spread, which is the difference between buying and selling price of a stock, for the average purchase cost 0.31% and average sale cost 0.69%.
- The average purchase in excess of $1,000 cost 1.6% in commissions, and the average sale in excess of $1,000 cost 1.5%
This means that to be worthwhile the average trade would have to boost return by 4%. Here we come to the nub of the problem: overconfidence. We are really bad at stock selection but we don't acknowledge that reality. Barber and Odean summarise their findings in this way:
"It is the cost of trading and the frequency of trading, not portfolio selections, that explain the poor investment performance of households during our sample period"
Men More Overconfident
When you think about share trading this is the image portrayed in the media.
Lots of screens. Lots of complicated graphs. Lots of men.
However investment is not trading. Investment is private individuals people putting their saved capital into markets to generate capital gains and income. In contrast the job of a trader, who usually sits in an investment bank or share broking company, is to act like an asset supermarket. Traders make money on the difference between buying and selling prices that they set and have to be willing to trade at any time as a market maker. Traders don't choose when they trade but they can set the bid and offer prices at which they trade. Traders don't bet on rising or falling prices, in fact they almost always hedge all their positions to avoid this.
Instead when you think about great investors your mental image should look more like this...
In 2001 Barber and Odean went on to study gender differences in overtrading and overconfidence. Using data from 35,000 households they found that the turnover rate for men was one and a half times higher than that of women. As before they found that net returns fell as turnover increased but the effect was greatest for men who lost 0.94% more per year than women. The difference in overtrading was greatest for single men and women.
Neither men nor women were good at stock selection. In fact this study (and others) showed that the stocks people bought earned less than the stocks they sold by a little less than 0.2% per month.
"Both men and women detract from their returns (gross and net) by trading; men simply do so more often"
Sensation Seeking
One criticism of research on the drivers of investment activity is that the link between overconfidence and overtrading is indirect. For example gender differences in trading activity combined with findings from other research showing men tend to be more overconfident than women suggest that overconfidence leads to overtrading. This led Mark Grinblatt and Matti Keloharju to look more directly at the link between overconfidence, sensation seeking and overtrading. Sensation seeking is an interesting confounding factor because it may offer an alternative explanatory factor driving excessive trading. Here's the definition of sensation seeking by Marvin Zuckerman, an expert on the topic.
"...a trait defined by the seeking of varied, novel, complex, and intense sensations and experiences, and the willingness to take physical, social, legal, and financial risks for the sake of such experience."
Marvin Zuckerman
Grinblatt and Keloharju used data from Finland where some rather draconian traffic laws helped them gauge whether Finns were sensation seekers. In Finland speeding tickets are means tested. In 2015 businessman Reima Kuisla was caught doing 64 mph in a 50 mph zone. His 2013 tax return showed that he earned 6.5m euros so his fine was 54,000 euros!
Such severe monetary penalties make the barrier to speeding so high that only true sensation seekers would even think of exceeding the speed limit. They also controlled for other factors such as wealth, income, age, number of stocks owned, marital status, and occupation.
They found that age affects the number of trades with younger investors trading more frequently. Only for very young Finns did trading increase with age as they graduate from college and complete their obligatory national service. Trading peaked at 23 years of age then tailed off with age.
Each additional income-related speeding fine increases the number of trades by a factor of 10.6%.
Another reason why Finland was an ideal country to run this assessment is that it has compulsory military service for men and they all take a Finnish Armed Forces leadership assessment. As part of this some of the questions they answer deal directly with overconfidence. This is how the Finnish Armed Forces describe overconfidence:
A person with a high score believes in himself. He views himself at least as intelligent as others and believes he will manage in life, if necessary, even without the help from others. He does not feel nervous or anxious in social situations; he does not expect others’ approval and is not afraid of others’ possible critique. A person with a low score is uncertain of himself and he may hate himself and his outlook. He gives up easily when facing difficulties and can even blame others for his failures: “he has been given too difficult tasks.” As a result of lack of self-confidence he feels himself unsure and anxious in social situations, and can therefore avoid particular individuals who are self-confident and view him critically
Using the armed forces questionnaire results Grinblatt and Keloharju showed that overconfidence is strongly related to overtrading.
Why are other people buying or selling?
Fundamental investors try to assess whether an asset is expensive or cheap based on pricing models. For example for shares the standard measure of value is the ratio of price to earnings. We simply take the share price and divide by how much earnings (profit) the company has generated i.e. how many pounds will you pay for every pound of profit generated?
However there are many valuation models. And there are multiple sources of information about companies and some of it is proprietary which means you and I will never see it. So let's say you run your favourite models and they show an asset is cheap. How is that possible? There are two possibilities:
- The market is right and you are wrong
- The market is wrong and you are right
Overconfident investors will always assume that they are right and the market is wrong, and so if the market diverges from their view of fundamental value they will trade aggressively. They are essentially ignoring a hugely valuable source of information: the opinion of other investors. That opinion is reflected in the asset price.
This led Jeffrey Hales to carry out an experiment to see if he could correct this blinkered approach to trading. In "Are Investors Really Willing to Agree to Disagree?" he created a simulated trading environment. Participants took part in repeated rounds of trading in pairs where they would each be shown their own "signal" estimating the true value of a share.
Hales found that when he prompted investors to assess disagreement with other investors over asset values this made them much less likely to overtrade. He summarised his findings in this way:
"These results have implications for how to model investor behavior. They provide strong evidence that a willingness to engage in speculative trade is largely driven by a failure to account for information about value implicit in other trader’s actions."
Jeffrey Hales
Overcoming Overconfidence
What are the practical ways we can overcome our overconfidence and tendency to overtrade? Some things we can't change, such as our age, or whether we have a sensation-seeking personality. What we can do is the following:
- Trading Reduces Net Return: This means we should trade as infrequently as possible. We should buy assets that we are willing to hold for as long as possible. We must resist the urge to tinker on the basis of news stories that we hear or the latest investment fad.
- Stock picking adds no value: Evidence shows that very few professional investors who manage funds, and even fewer non-professional investors can reliably pick single stocks that outperform the stock market as a whole. The alternative is now easy and cheap, which is to buy whole markets through cheap Exchange Traded Funds.
- Minimise Fees: Don't pay for an expensive broker, an expensive platform or expensive products with high management fees. Researching fees is a highly productive use of your time.
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