Foundations of Knowledge:

               "Do investors trade too much?"


REVIEW

The stock market has become the point of attraction from the last few years. More and more people are engaging themselves in trading of shares. The fluctuations in the stock market are the result of frequent trading of the shares as the prices of shares are largely depends on demand and supply concept. The journal "do investors trade too much" by Terence Odean(1999) tries to explain the cause behind investors engaging themselves in frequent trading. The discussion by Terence describes the test of excessive trading and present results, performance pattern of securities before and after sale. Even Odean has identified "overconfidence in investors" as the main cause of frequent trading.


INTRODUCTION

Financial market is a mechanism that allows people to easily buy and sell financial securities such as stocks, bonds etc (Wikipedia Encyclopedia). This market is a place which provides investors an opportunity to earn returns on their savings. But the desire of earning more and more returns on investments makes investors to trade frequently. The following patterns are examples of frequent trading in any 90 day period:

  1. Buy, Sell, Buy, Sell, Buy, Sell;

  2. Buy, Buy, Sell, Buy, Sell, Sell;

  3. Buy, Buy, Buy, Sell, Sell, Sell. (ICMA-RC's Frequent Trading Policy)

The share turnover rate on the NYSE in 2005 was about 103%, amounting to a total volume of more than 400 billion shares (Tarun chodia, 2009).

French (2008) suggests that the public has spent around $99 billion on these transactions in 2006. This high turnover of shares is nothing but result of excessive trading. Investors believe that excessive trading will result in more returns on their investments. We find that higher turnover has been associated with more frequent smaller trades, which have progressively formed a larger fraction of trading volume over time (Tarun chodia, 2009). According to Odean the trading volume of particular class of investors i.e. discount brokerage accounts is excessive. Alexandros V. Benos (1998) and Odean

(1998a) propose that, due to their overconfidence, investors will trade too much. The further part explains why excessive trading takes place and theory behind overconfident investors ?


INVESTORS OVERCONFIDENCE AND THEIR PREDICTION

The investors are overconfident about their abilities and about their knowledge (Jerome D. Frank, 1935), may be because they have earned more returns on investment in past (Ellen J. Langer and Jane Roth,1975; Dale T. Miller and Michael Ross,1975)�. According to Amos tversky (1992) when the investors cannot predict about the future of the securities, the experts becomes over confident about their skills and results in frequent buying and selling of securities.

The irrational investors cannot assess their expected profits from trading (Sanford J. Grossman and Joseph E. Stiglitz (1980), because overconfidence lowers their expected utility. They just sell their stock without thinking about cost of trading, they have unrealistic beliefs' about their expected profits and results in loss on their investment.

Overconfidence investors believe that they have useful information, but infact they have no information (Benos,1998 and Odean 1999).

As per the test performed on these investors it was found that not only do the securities that these investors buy, not outperform the securities they sell by enough to cover trading costs, but on

average the securities they buy underperform those they sell. So the investors earn less return on the securities he buys as compare to the securities he owned before. Along with the investors has to bear the trading cost.


METHODOLOGY

Odean conducted a test to find out overconfidence in investors for precision of information. He determines whether the securities investors buy outperform the securities they sell within a horizon of four months, one year and two year. According to Odean;s calculation, the average commission paid on the securities purchased is 2.23 of the purchase price and commission on sale is 2.76. So, if the trading of securities is done then the returns on security should be more than 5.9 percent to prove that they have not misinterpret the information.(Odean 1999).

According to Odean there are various reasons for which investors trade frequently such as increase profit, move to less risky investments, to realize loss, to balance the portfolio etc, liquidity motive etc.


RESULTS

It was found that not only the investors are paying 5.9 percent transaction costs to buy another security, but the securities they buy underperform the security they sell. This is may be because they misinterpret the information or infact they have no information it's just overconfidence (Odean 1999) .

It's found that these investors are not taking profitable trades, so the trade is not for profit motive. The securities are bought again within three weeks, so the motive is not liquidity as there are other cheaper ways of funding (Odean 1999).


CAUSES OF LESS RETURNS ON SECURITY

As per Odean, there are various reasons which states that why securities underperformed. One possible reason is security selection and market timings. The investors may have misinterpreted the information and have chosen the wrong security, i.e. poor choice of which security to buy and which to sell (Odean 1999).


CONCLUSION

The conclusion is that the some class of investors trade too much, particularly retail investors are participating to a greater extent because of enhanced access to online trading (Barber and Odean, 2000). Another is overconfident investor's trade excessively. Overconfident investors may trade even when their expected gains through trading are not enough to offset trading costs.

The more these investors trade, the expected utility gets lower. Therefore they cannot assess their expected profits from trading and results in loss in transactions.


BIBLOGRAPHY

E-JOURNALS

� WHY HAS TRADING VOLUME INCREASED

BY TARUN CHODIA, RICHARD ROLLAND AVANIDHAR SUBRAHMANYAM (MARCH 24,2009)

http://ssrn.com/abstract=1364006

� DO INVESTORS TRADE TOO MUCH

BY TERENCE AND ODEAN (1999)

� WIKIPEDIA ENCLYCOPEDIA

� ICMA RC "FREQUENT TRADING"

http://icma-rc.org/xp/rc/about/frequenttrading/faq.html?audience=main&showSidebar=yes

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/do-investors-trade-too-much.php


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