“Trading is Hazardous to Your Wealth” Barber & Odean (2000)
This paper is the classic reference on the cost to investors of individual stock overtrading. While the last paper covered on this blog showed that these costs are extremely economically meaningful in the aggregate, this paper focuses on the immediate impact that overtrading has on investor returns.
The striking result of this paper is that although the before-cost returns to investors are nearly unaffected by overtrading, the net after-cost returns are incredibly divergent. Before-cost average returns are clustered around 18.5%-18.7%/year. But the investors who trade most frequently in this sample earn an average after-cost return of 11.4%/year, compared to 18.5%/year for those who trade the least (and a return of 17.9%/year for the market).
The average annual portfolio turnover in this sample is 70%, and small account holders tend to have a higher turnover than large account holders. The authors argue that the poor performance of high turnover investors is due to overconfidence. My reading is a little different. If investors were overconfident then shouldn’t this also be reflected in a before-cost deficit? But individual investors actually outperform the market before costs. The clear negative relationship between costs and returns seems to me that investors are simply not accounting for the deleterious effects of costs. Large account holders likely have more appreciation for the total costs of trading and hence turn their portfolios over less frequently.
As I’ve argued in the last blog post, I think this could be because a major cost of trading, the bid-ask spread, is not a cost that is cognitively accessible. Investors have to infer it from looking at the spread. Making the cost of the spread clear, by multiplying the number of units bought or sold on each transaction by half the spread, could be a useful nudge.
This could have a number of beneficial knock-on effects. Investors could begin to trade more patiently, supplying more liquidity to the market instead of demanding it. Furthermore, increased cost-sensitivity would incentivise market-makers to quote more competitive prices. Individual investors’ trades tend to be highly correlated. Could it be that getting them to trade less often would help decrease the formation of financial bubbles?
Consumers are liquidity demanders. Make them demand less and increase their supply. Incentives for market makers to quote more competitively.