Monday, 14 June 2010

Investors' Greatest Sins

From the pages of Yahoo!Finance comes this:

Overconfidence. Humans seem to be hardwired to expect success and to regard themselves as above average. Odean likes to hammer this point home to his M.B.A. students by asking them to rate their driving abilities. "Above average" is the virtually unanimous response. One of the few students who rated herself merely an average driver was, in fact, about to lose her license for having had three accidents in the past year.

Overconfidence permeates the ranks of investors, especially men, Odean concluded in a study with finance professor Brad M. Barber from UC, Davis. Looking at the trading patterns of 35,000 households over five years, they found that single men's confidence in their ability to outperform the market prompted them to trade 67% more frequently than did unmarried women. The payoff for all this activity was negative; the men's portfolios underperformed those of the less-frenetic women by 1.4 percentage points per year, Odean and Barber found.

Excessive trading. Princeton finance professor Burton Malkiel has argued that investors are on a fool's errand in trying to outperform an efficient market in which all relevant information is reflected in equity prices. Odean agrees that trying to beat the market is a loser's game for small investors but for a somewhat different reason. He thinks the casino is rigged in favor of large institutions.

Looking at every trade made on the Taiwan Stock Exchange over four years, Odean found that commissions, taxes and poor timing of buy and sell decisions sucked a collective $32 billion out of the pockets of individual investors over the period studied. (The exchange's listings have a combined market value of $660 billion.) The winners in this game: middlemen and institutions.

Even when the little guy thinks he's in the know, he is often clueless about what's going on behind the scenes. Not so the big guys, Odean argues.

"For an individual to not believe that he's at an informational disadvantage when he's trading against guys from Goldman Sachs is naive," he says. "It's like deciding to play one-on-one with a professional basketball player. You're going to lose."

Going with the crowd. Like children fighting over the same toy, investors are often attracted to stocks because others want them. In fact, individuals are much more likely to buy and sell the 10% of stocks mentioned in the news and ignore the other 90%, he found.

The problem with buying stocks when they're popular rather than on the basis of fundamental value is that they tend to be expensive and susceptible to changes in investor sentiment.

The day after a stock ranks among top performers, two-thirds of all trades by individual investors are buys (institutions, by contrast, tend to wait for dips in prices and trading volume). Over the following month these hot issues underperform the overall market by an average 1.6 percentage points, Odean found in a 2006 study. Adding salt to the wound, Odean tells us that more often than not the stocks that investors sell outperform the ones they buy.

Stubbornness. Savvy investors sell losers to book tax losses, offset gains and stiff Uncle Sam. Logical as this is, few investors are willing to admit defeat. That was Odean's conclusion after analyzing 10,000 discount brokerage accounts over three years. The exercise revealed that investors are more likely to sell winners and trigger capital gains taxes than to sell their losers and avoid them.

The damage doesn't stop there. In addition to the tax drag such behavior entailed, Odean found that in the year after they were sold winning stocks went on to gain 3.4 percentage points more than the losers to which investors clung.

If you're sure you're an above-average investor, go ahead and trade like a fiend. But keep in mind the possibility that you are fooling yourself and would do better buying index funds and focusing on becoming a better driver.

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