“Just How Much Do Individual Investors Lose by Trading?” Barber, Lee, Liu & Odean (2006)
This paper uses a remarkably complete dataset on the Taiwanese stock market from 1995-1999 to examine the magnitude of investors’ losses from overtrading. Barber and Odean are the authors of the seminal paper on overtrading, showing the very clear negative relationship between portfolio turnover and investment returns. The advantage of the dataset in the 2006 paper is that it can be used to precisely measure these losses for individual investors in an entire country, and also show who these losses flow to.
Many of the papers discussed on this blog are about mutual funds. The Taiwanese market is peculiar in that only 1% of individuals’ investments are through mutual funds or other intermediaries; the rest is through direct investment in individual stocks. Additionally, turnover is incredibly high, at around 300%/year (the average stock is held for only around 4 months). These features make the market almost a perfect microcosm of the costs of individual stock overtrading.
The results are truly staggering: individuals lose 2.2% of GDP per year due to their overtrading.
Individual stock trading can be thought of as a zero-sum game. If one investor outperforms relative to the market, then this must be mirrored by another investor’s underpeformance. So who wins from individual investors’ overtrading? Financial institutions. Much of this flows overseas to large institutional investors. From a social welfare perspective, it seems clear that limiting some of this large wealth transfer would be beneficial.
Investors’ losses are primarily through their most aggressive trades. Demanding immediate liquidity leads to excess returns for liquidity providers (market makers, and large institutional traders). Institutions, on the other hand, gain both with their aggressive and passive trades. The authors state that this is probably because of their superior market knowledge.
How can we reduce individual investors’ losses? My own feeling is that overtrading might partly be caused by the unusual representation of costs in investing. The bid-ask spread is the main cost for individual stock trading. For a round-trip transaction – buying one stock and purchasing another – this can easily amount to 5% of the amount bought and sold. Given that long-term expected stock returns are around 6%/year, this takes out a large chunk. And turning your portfolio over three times a year, as the average Taiwanese did in this study, could easily cost you 15% (before accounting for taxes and the direct cost of transacting).
But the bid-ask spread is not a salient cost. It is paid implicitly through selling your actual holdings for a low price and buying your new stocks at a high price. There are few implicit costs such as this in the real world. Buying and selling on Ebay, for example, leads to direct fees that are easily measured. And another issue with the bid-ask spread is that its constant corroding effects are masked by high stock volatility. A way of making the bid-ask spread salient would be to multiply half the spread by the number of units being bought or sold. If the spread is 5%, and an investor is trying to sell £10,000 of stock, then before confirming the transaction they might be informed that the total implicit cost of this trade is £250 (whereas the direct brokerage cost of this trade might only be £10). It would be fairly trivial to mandate this information disclosure on online trading platforms, and my feeling is that it would greatly reduce the incidence of overtrading – and could go some way towards reducing the massive wealth transfer towards financial institutions.