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Overconfidence and Trading

Getting in Touch With Your Feminine Side Might Improve Portfolio Returns!


Portfolio Point: Many investors are overconfident.  This overconfidence sees investors destroy portfolio value by trading too often and by selling investments that end up performing better than the replacement investments.  For the research cited in this article female investors, who tend to be less overconfident than males and who trade less often, have portfolios that perform about 1% better that male investors.  The two common mistakes that come from overconfidence are trading too often, and being too quick to sell winning stocks while being too slow to sell losing stocks. 


The mathematics behind the distribution of investment returns that share market participants will receive is interesting.  The average share market return will be the share market index return, which is the return from all share market investments, less the costs associated with trading such as brokerage, fund manager fees, commissions and research.  So the average market participant will actually get a return equal to the share market index return less costs.  Let us assume that the share market index return for a given year is 12%.  If, on average, the brokerage, management fees, research and commission paid by investors is 2%, then the average investor will get a return of 10% a year. 


Even with the hard mathematics of the average return, I have never seen any investor say that they expect to do 'a little bit worse that the share market index returns'.  Almost all fund managers say that they expect their fund to outperform the index benchmark.  Similarly promoters of share trading software promise above average share market returns.  Brokers expect to have client portfolios positioned so that they will provide above average returns.  Individual investors generally expect their portfolio to provide above average return.  Overconfidence seems to be in good supply.


If everyone expects above average return, then at least half of them, and even more taking into account costs, are going to be disappointed. 


In 2001 United States finance academic Brad Barber and Terrance Odean published the paper "Boys will be Boys: Gender, Overconfidence, and Common Stock Investment" in the Quarterly Journal of Economics.  This paper is particularly interesting in that it considers the problem of overconfidence by examining the trading patters of 35,000 clients from an online broking firm.  This provides an insight into the trading patters of average ?mum and dad' investors.


To isolate the variable of overconfidence they rely on psychological research that demonstrates, on average, men are more overconfident in the area of finance than women.  So by comparing the trading patters of man and women they can consider the effects of overconfidence.


Consistent with men being overconfident, the study found that men traded more than women.  Men had a portfolio turnover rate of 77% annually, women 53%.  This means that men bought and sold more than three quarters of the value of their portfolio annually.  On average, men earned a return 2.65% lower than if they had simply held the portfolio that they owned at the start of the year.  Women earned a return 1.72% a year lower than if they had simply held the portfolio that they owned at the start of the year.  On average both men and women sold shares that earned a better return than the shares that they bought, the difference in the overall return is that men traded more frequently.  Both groups would have been significantly better off simply holding the portfolio that they owned at the start of the year and not trading at all.


In a later paper entitled "The Courage of Misguided Convictions: The Trading Behaviour of Individual Investors" published in the Financial Analysts Journal in 1999, Barber and Odean looked at 10,000 broker accounts held during the period 1987 to 1993.  The 20% of accounts that traded most frequently earned an average return of 11.4% a year.  The 20% of accounts that traded least frequently earned a return of 18.5% a year.  This is a clear example that excessive trading is destructive to portfolio returns.  This same study also found that investors were 50% more likely to sell a holding that had gone up in value than one that had gone down, and that this tendency negatively impacted on portfolio performance.


In this year's annual letter to Berkshire Hathoway investors Warren Buffet, surely one of the most successful investor of all time, discusses the investment industry and the noise, expense and activity associated with it.  His discussion led him to propose a Fourth Law of Motion.  'For investors as a whole, returns decrease as motion increases'. 


It seems that the very wise 'Sage of Omaha', Warren Buffet, and the academic studies cited in this article lead us to the same conclusion - sometimes less is more in the world of investing.


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