In 2000, Brad M. Barber and Terrance Odean, both of the Graduate School of Management at UC Davis, published what would become a reference work in all future studies on overtrading. The gist of their research is this:
Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.
One of the advantages of investing in index funds, as FutureAdvisor recommends, is that you’re choosing to make fewer choices, with full knowledge that many of those choices, on average, would have been wrong.
Barber later led a different team of researchers to study retail investors in Taiwan. Since most Taiwanese investors buy more individual stocks and sell them more often, the results of the 2006 study were even clearer. Trading will lose you money.
We document that individual investor trading results in systematic and, more importantly, economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2 percent of Taiwan’s GDP or 2.8 percent of total personal income – nearly as much as the total private expenditure on clothing and footwear in Taiwan. Using orders underlying trade, we document that virtually all of individual trading losses can be traced to their aggressive orders; passive orders placed by individuals are profitable at short horizons and suffer modest losses at longer horizons. In contrast, institutions enjoy an annual performance boost of 1.5 percentage points (after commissions and taxes, but before other costs). Both the aggressive and passive trades of institutions are profitable.
Photo – Ahmad Nawawi