"I am concerned about the growing gap between the (bubby and frothy) stock market and the real economy" said Nouriel Roubini, professor of New York University, in the BBC news. Over the last six months, the Dow Jones Industrial Average has risen about 45%. But Prof. Roubini says he sees an economy where consumers are "shopped out" and "debt burdened"(Michelle Fleury, 2009). It is just one year after the collapse of Lehman Brothers. However, it seems that investors have already forgotten the lesson learnt from the credit crunch in 2008. Why don't investors learn? Ten years ago, Terrance Odean, Professor of University of California, proposed that they do learn, but slowly (Odean 1999 pp.1279-1298). Do investors trade too much? Odean's work in 1999 would be discussed and reviewed today.
The main objective of Odean's paper - "Do Investors Trade Too Much" is to find out if investors are trading excessively, in other words, if there's reduction on their returns through trading. Although many indicators could be used to show the trading volume, no model can forecast the trading volume in real markets. Hence, it is arduous to examine if observed volume is excessive or not. Odean (1999) proposes that, if trading is excessive for a market as a whole, then it must be excessive for some groups of participants in that market. This paper illustrates that the trading volume of a specific group of investors - with Discount Brokerage Account 1 is excessive.
These accounts allow investors to purchase stocks, bonds and other investments by paying professionals to buy or sell the items. The fee investors pay is called a "commission", and can range from as low as $5 to $10 dollars, to upwards of several hundred dollars.
In Odean's paper, he assumed that investors were trading too much in the market. Hence, to find out if investors trade too much, Alexandros V. Benoa (1998) and Odean (1998) proposed statement - "due to their overconfidence, investors will trade too much" had been tested in this paper's hypothesis. Odean assumed that overconfidence 2 is the reason why investors' returns are reduced through trading. Investors, however, would be overconfident in two ways from Odean's assumptions: 1. Overestimate the precision of their information; 2. Overconfidence about their ability to interpret information. By these two assumptions, Odean put them into two hypothesizes. These two hypotheses would be discussed in the later part.
First of all, ten thousand discount brokerage accounts were chosen randomly for this research. The reason for choosing discount brokerage accounts to test the overconfidence theory is that other accounts, such as retail brokerage accounts, excessive trading may result from brokers churning accounts to get commission or overconfidence from agency relationship (Odean, 1999).
2 Psychologists show that most people generally are overconfident about their abilities (Jerome D. Frank, 1935) and about their the precision of their knowledge (Baruch Fischhoff et al., 1977; Marc Alpert and Howard Raiffa, 1982; Sarah Lichtenstein et al., 1982) Traders who have been successful in the past may overestimate the degree to which they were responsible for their own success - as people do in general (Ellen J. Langer and Jane Roth, 1975; Dale T. Miller and Michael Ross, 1975) - and grow increasingly overconfident.
As mentioned above, due to their overconfidence, investors will trade too much. Investors' overconfidence upon the precision of information or misinterpret useful information or both, they will trade even suffering loss. In order to test for overconfidence in precision of information, Odean testified if the securities that investors in this data set buy outperform those they sell by enough to cover the costs of trading, that is the first hypothesis (N1). On the other hand, to test for biased interpretation of information, Odean testified if the securities that they buy underperform those they sell when trading costs are ignored, and that is the second hypothesis (N2).
The first hypothesis (N1) was testified over four months, one year and two years horizons regarding the average returns to securities bought minus the average returns to securities sold are less than the average round-trip trading costs of 5.9 percent. The null hypothesis (N1) is the difference in returns must be equal or greater than 5.9 percent. The second hypothesis (N2) was examined over the same period of time with the average returns to securities bought are less than those securities sold, ignoring trading costs. The null hypothesis (N2) is the average returns to securities bought are greater than or equal to those sold.As a result, in table 1 - average returns following purchase and sales, both N1 and N2 were rejected from panel A to panel F 3. It indicated that overconfidence investors trade even when their expected gains by trading are not enough to cover the trading cost. More surprisingly, even Odean eliminated the trading cost; these investors still reduced their returns through trading.
3 More Details could be found in "Do Investors Trade Too Much" Table 1 - Average Returns Following Purchases and Sales, pp 1284
Odean (1999) endeavored to explain why these investors suffer loss through excessive trading by illustrating how these overconfident investors misinterpret a wide variety of the same sort of information, e.g. accounting data, financial statement. In order to analyzing the case, the return patterns to securities before and after they are purchased and sold by individual investors had been used. From the figures, Odean (1999) found that investors tend to purchase similar amount of winners4 and losers5, but they sell far more winners than losers. Odean (1999) suggested that for most investors decision to buy is different from the decision to sell. That is, the buying patterns are forced by the vast amount of securities that investors can choose from and how investors' attention be driven by securities that experienced unusually good or bad performance. As investors are not able to evaluate every securities in the stock market, they will then buy those securities were discussed in the media that have preformed abnormally well or poorly.
4 "Do Investors Trade Too Much", in figure 3 and 4 the purchase and sales of the 90 percent of investors who trade least are partitioned into previous winner and losers. A security that had a positive raw return over the 126 trading days (six months) preceding a purchase or sale is classified as a previous winner.
3 "Do Investors Trade Too Much", in figure 3 and 4 the purchase and sales of the 90 percent of investors who trade least are partitioned into previous winner and losers. A security that had a negative raw return over the 126 trading days (six months) preceding a purchase or sale is classified as a previous loser.
For selling patterns, however, is affected by investors' reluctance to sell and the disposition effect6. Due to psychologically motivated, investors want to avoid losses and thus sell the winners. Therefore, they keep their losing securities and sell their winning securities. When combining the buying and selling patterns of these investors, three reasons can be concluded to explain why these investors suffer loss through excessive trading. They are attention focusing7, the disposition effect and the reluctance to sell8.
Odean claimed that his paper has illustrated that overall trading volume in stock market is excessive. He showed us that the average investment returns of investors with discount brokerage accounts reduced through trading. "Due to overconfidence, investors trade too much" was tested in the hypothesis. Odean found that overconfidence investors trade even when the expected returns are not enough to cover the cost of trading. Even eliminating trading cost, these investors were still lower their returns through trading.
6This Behavior is predicted by Hersh Shefrin and Meir Statman's disposition theory (1985) and, in more general terms, by Daniel Kahneman and Tversky's prospect theory (1979). It appears that for many investors the decision to sell a security is more influenced by what that security has done than by what it is likely to do.
7Security that have performed usually well or poorly are more likely to be discussed in the media, more likely to be considered by individual investors and, ultimately, more likely to be purchased (Odean, 1999).
8Odean (1998b) shows that these investors strongly prefer to sell their winning investments and to hold on to their losing investments even though the winning investments they sell subsequently outperform the losers they continue to hold. Jeffrey Heisler (1997) and Chip Health at al. (1999) find that investors display similar behavior when closing future contracts and exercising employee stock options.
Furthermore, by examining return pattern before and after the purchase and sales made by these investors, Odean has found how these investors' buying and selling pattern made them suffer losses by attention focusing, the disposition effect and the reluctance to sell. His message is simple and true. Investing is profitable, but trading excessively is hazardous to your wealth (Brad 2006 pp.1-6).
However, several limitations have been found in this paper. As only the investors with discount brokerage accounts are studied in this paper, therefore the projection of the results may not apply to other investors without discount brokerage accounts. Secondly, accounts that were closed are not replaced; therefore, in the later year of the sample data set might have survivorship bias. Thirdly, this paper only looks at trade of NYSE, American Stock Exchange and NASDAQ; thus some other major stock markets in Asia and Europe are neglected, such as HangSeng Index, FTSE 100. Furthermore, the data from this paper was conducted from 1987 to 1993, which were good years to invest in the market, may not reflect the whole picture of stock trading pattern, such as in 1997 Asian Financial Crisis9. Also, the data in 1987 may not reflect the real investors trading behavior in 2009, due to many new investment tools have been invented recent years as more advanced technologies that enable investors to trade even much more easily.
9 The Asian financial crisis was initiated by two rounds of currency depreciation that have been occurring since early summer 1997. The first round was a precipitous drop in the value of the Thai baht, Malaysian ringgit, Philippine peso, and Indonesian rupiah. As these currencies stabilized, the second round began with downward pressures hitting the Taiwan dollar, South Korean won, Brazilian real, Singaporean dollar, and Hong Kong dollar. The currency crises also has revealed severe problems in the banking and financial sectors of the troubled Asian economies.
Michelle Fleury , 2009, World financial crisis 'not over' , [television broadcast], BBC News, BBC News Chanel 8/10/2009.
Richard A. Brealey & Stewart C. Myers & Alan J. Marcus 2007, Fundamentals of Corporate Finance, 5th ed., McGraw-Hill, U.S.
Joshua Kennon, About.com 2007 'What is a Brokerage Account'. http://beginnersinvest.about.com/cs/brokers1/f/wtisbrokeracct.htm (accessed 2007)
Brad M. Barber & Terrance Odean 2006, 'Research Summary - Why do Investors trade too much?', Research Summary, 2006, pp1-6
Ruth O'Callaghan 2004, 'Assess your own shortcomefore investing', The Sunday Times, 4/01/2004, pp1-2
Bryman, A. and Bell, E. 2003, Business Research Methods, 1st ed., Oxford University Press, U.K.
Greetham, B 2001, How to Write Better Essays, 1st ed., Palgrave.
Richard Freeman & Ronald Schettkat 2000, 'LOW WAGE SERVICES: INTERPRETING THE US - GERMAN DIFFERENCE', NBER WORKING PAPER SERIES, 03/2000, pp16-27
Terrance Odean 1999, 'Do Investors Trade Too Much', The American Economic Review, 12/1999, pp1279-1298.
Dick K. Nanto 1998, 'THE 1997-98 ASIAN FINANCIAL CRISIS', CRS Report, 6/2/1998, pp1-6
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