Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance Of Individual Investors
Brad M. Barber And Terrance Odean*
Abstract
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.
Trading Is Hazardous To Your Wealth: The Common Stock Investment Performance Of Individual Investors – Introduction
The investor’s chief problem–and even his worst enemy–is likely to be himself. — Benjamin Graham
In 1996, approximately 47 percent of equity investments in the United States were held directly by households, 23 percent by pension funds, and 14 percent by mutual funds ~Securities Industry Fact Book, 1997!. Financial economists have extensively analyzed the return performance of equities managed by mutual funds. There is also a fair amount of research on the performance of equities managed by pension funds. Unfortunately, there is little research on the return performance of equities held directly by households, despite their large ownership of equities.
In this paper, we attempt to shed light on the investment performance of common stocks held directly by households. To do so, we analyze a unique data set that consists of position statements and trading activity for 78,000 households at a large discount brokerage firm over a six-year period ending in January 1997.
Our analyses also allow us to test two competing theories of trading activity. Using a rational expectation framework, Grossman and Stiglitz ~1980! argue that investors will trade when the marginal benefit of doing so is equal to or exceeds the marginal cost of the trade. In contrast Odean~1998b!, Gervais and Odean ~1998!, and Caballe and Sákovics ~1998! develop theoretical models of financial markets where investors suffer from overconfidence. These overconfidence models predict that investors will trade to their detriment.
Our most dramatic empirical evidence supports the view that overconfidence leads to excessive trading ~see Figure 1!. On one hand, there is very little difference in the gross performance of households that trade frequently ~with monthly turnover in excess of 8.8 percent! and those that trade infrequently. In contrast, households that trade frequently earn a net annualized geometric mean return of 11.4 percent, and those that trade infrequently earn 18.5 percent. These results are consistent with models where trading emanates from investor overconfidence, but are inconsistent with models where trading results from rational expectations. Though liquidity, risk-based rebalancing, and taxes can explain some trading activity, we argue that it belies common sense that these motivations for trade, even in combination, can explain average annual turnover of more than 250 percent for those households that trade most.
We also document that, overall, the households we analyze significantly underperform relevant benchmarks, after a reasonable accounting for transaction costs. These households earn gross returns ~before accounting for transaction costs! that are close to those earned by an investment in a value-weighted index of NYSE0AMEX0Nasdaq stocks. During our sample period, an investment in a value-weighted market index earns an annualized geometric mean return of 17.9 percent, the average household earns a gross return of 18.7 percent, and in aggregate households earn a gross return of 18.2 percent. In contrast, the net performance ~after accounting for the bid-ask spread and commissions! of these households is below par, with the average household earning 16.4 percent and in aggregate households earning 16.7 percent. The empirical tests supporting these conclusions come from abnormal return calculations that allow each household to self-select its own investment style and from time-series regressions that employ either the Capital Asset Pricing Model ~CAPM! or the three-factor model developed by Fama and French ~1993! as our benchmark.
Common Stock Investment Performance
Our descriptive analysis provides several additional conclusions that are noteworthy:
- Households trade common stocks frequently. The average household turns over more than 75 percent of its common stock portfolio annually.
- Trading costs are high. The average round-trip trade in excess of $1,000 costs three percent in commissions and one percent in bid-ask spread.
- Households tilt their investments toward small, high-beta stocks. There is a less obvious tilt toward value ~high book-to-market! stocks.
It is the cost of trading and the frequency of trading, not portfolio selections, that explain the poor investment performance of households during our sample period. In fact, the tilt of households toward small stocks and, to a lesser extent, value stocks helps their performance during our sample period ~during which small stocks outperform large stocks by 15 basis points per month and value outperforms growth by 20 basis points per month!.
The remainder of this paper is organized as follows. We discuss related research in Section I and our data and empirical methods in Section II. Our main descriptive results are presented in Section III. We test the models of investor overconfidence in Section IV. We discuss the impact of price momentum on individual investor performance in Section V and liquidity, risk, and taxes as motivations for trading in Section VI. Concluding remarks are made in Section VII.
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