CalBusiness

 

Summer 2007

Power of Ideas

Individual Investors See Red

Average investors lose when they trade stocks, says Prof. Terry Odean.

 

By Ronna Kelly

 

Finance Professor Terry Odean, PhD. 97, compares amateur stock trading to a tourist playing poker with the professionals in the smoky backroom of a Las Vegas casino.

 

"The institutional investors are the pros. They are the guys who show up in that backroom every day, and that's how they make their living," Odean says. "When you start trading actively, you are betting you are going to outsmart the pros, who are historically smarter."

 

"I do think that people make money in the market through skill, but those people are not part-time, amateur investors," he adds.

 

Odean should know: He has been studying behavioral finance since 1993, and his findings don't bode well for individual investors. "The average investor gets it wrong," says Odean, the Willis H. Booth Chair in Banking and Finance I.

 

Odean elaborated on exactly how wrong in a recent working paper titled "Just How Much Do Individual Investors Lose by Trading?," which he coauthored with Brad Barber of the University of California, Davis, and Yi-Tsung Lee and Yu-Jane Liu, both of the National Chegchi University in Taipei. The paper is based on the most comprehensive sample of trading behavior ever studied: all trades by all investors on the Taiwan Stock Exchange from 1995 to 1999.

 

According to Odean's research, the trading activities of individual investors reduce individuals' annual returns by 3.8 percentage points. Odean and his co-authors estimated that trading losses by individual investors totaled a whopping $32 billion during the sample period -- the equivalent of 2.2% of Taiwan's gross domestic product or 2.8% of total personal income.

 

"The losses by individuals in Taiwan were shocking," Odean says. "It's a lot of money."

 

At the same time, trading by institutions increased institutional returns by 1.5 percentage points annually. Those findings contradict arguments made by some academics who maintain that institutions don't make money in the stock market after paying for transaction costs.

 

When profits are tracked over six months, foreigners - foreign banks, insurance companies, securities firms, and mutual funds - earn nearly half of all institutional trading profits in Taiwan. "The profits of foreigners represent an unambiguous wealth transfer from Taiwanese individual investors to foreigners," Odean says.

 

There are, however, some differences between the Taiwan Stock Exchange and US stock markets. Taiwanese investors trade stocks nearly three times more frequently than investors on the New York Stock Exchange. That means Taiwanese investors pay more in transaction costs, which subsequently eat away at their gains. Odean and his coauthors estimated that slightly less than two-thirds of the losses suffered by Taiwanese individual investors stem from transaction costs.

 

Moreover, the majority of investors in the Taiwan Stock Exchange are individuals, who account for roughly 90% of all trading volume.

 

Odean hasn't been able to quantify the proportion of US stock market investors who are individuals, but it's clearly lower than in Taiwan. That means the other side of a stock trade by an US individual investor is more likely to be an institution who knows more than the individual.

 

"There's a nine-out-of-ten chance that an individual investor in Taiwan is trading with another individual who is equally uninformed, and there's only a one-in-ten chance the individual is trading with an institution who is better informed," Odean notes.

 

"In the U.S., there are more sharks in the water," he adds, referring to professional institutional stock traders.

 

In a previous analysis of trades through a US discount brokerage, Barber and Odean estimated that individual investors reduced their returns by about 2 percentage points through trading, which is about half the loss of Taiwanese individuals.

 

What does all this mean for active stock market investors in the US?

 

Odean believes individual investors should stay away from trading individual stocks and instead opt for a market-wide index fund plus some overseas funds. "People should focus on the things that they can control - fees, trading costs, and diversification," he says.

 

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Professor Terry Odean, PhD. 97

Finance Professor Terry Odean, PhD. 97