Buy and hold

(September 2008) Have you dealt with clients who, riddled with bullish bravado, forced you to buy when the market spikes, and sell when the bear turns on them? Terrance Odean, professor of banking and finance at the University of California at Berkeley, says the best way to deal with such fidgety clients is to use insights from behaviourial finance to understand and guide them.

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As a leading U.S. investor-behaviourial expert, Odean is a prolific researcher of trading habits. His raw data consists of the actual trading records from thousands of individual-investor brokerage accounts in the ’90s. As a result Odean, and his collaborators, have plumbed through this unique database to catalogue the many ways small investors undermine their own results.

In an initial research project, Odean divided the small-investor records into five groups, based on frequency of trading. The most active group trailed the most passive by an average of 7% each year. On a $10,000 investment, that adds up to a deficit of roughly $8,000 over six years.

Through this research, Odean has come to believe that while confidence is a factor in trading, overconfidence is far more problematic. Another pervasive problem is an investor’s inability to predict market timing. Small investors habitually overestimate their ability to predict the future, and fitfully trade in and out of stocks.

Based on the trades of 10,000 investors at a large discount trading firm, Odean observed that those who traded stocks that were in the news, when maximum attention was focused on them, enjoyed no benefits. In fact, Odean found that excluding transaction costs, newly acquired stocks actually underperformed the stocks that were sold.

Curious as to how much of an impact dreadful market timing had on these investors, Odean looked at the performance of stocks after the trades took place. On average, the stocks these investors bought underperformed the stocks they sold by 3.2% over the next year, and 3.6% after a two-year period. This was before deducting commissions. To make matters worse, rather than admitting their mistake, investors held on to the losers for far too long.

That’s not all. Odean found that over-confidence also led to another seminal mistake: under diversification. Based on his research, Odean found that employees who invest one-fourth of their assets in company stock sacrifice 42% of the stock’s market value relative to holding a well-diversified portfolio. “While an over diversified portfolio will never make you as rich as Bill Gates, it will also never lose all your money,” says Odean. “Look at what happened to the 62% of Enron employees who only invested in company stock.”

Not surprisingly, Odean’s research also showed significant differences between the trading habits of men and women. In a 2001 study, men claimed to have greater investment ability than women. However, the data indicated that the performance of single men was 1.4% lower than the trading performance of single women.

Unfortunately, combating a client’s perception of market confidence is far more difficult for advisors in today’s world of technological advancements. Now, many clients and investors have access to a lot of online data and this tends to feed investor over-confidence. But access to more knowledge isn’t necessarily an advantage, says Odean. “You assume you’ll make more [money] if you know more, but some investors get overwhelmed and make unwise decisions.”

Odean noted, in a 1999 report, that before going online, investors outperformed the market by 1.9%. This outperformance disappeared when these investors moved to online trading, underperforming the market by an average of 3.6%.

“Individual investors who wake up at 2 a.m. and are tempted to trade online should go back to bed,” recommends Odean. “When you get up in the morning, if you’re still hot on the stock, do diligent research or speak to an experienced advisor if you want to protect your wealth.”

This article first appeared in the July 2008 issue of Advisor’s Edge Report.

Filed by Kanupriya Vashisht, Advisor’s Edge. kanupriya.vashisht@advisor.rogers.com