Stock investing: academic evidence
Overconfidence, loss aversion dominate trading decisions
Last week I wrote of my personal views on why most individuals are ill equipped to buy and sell individual stocks directly. My concerns are founded on a lack of a disciplined evaluation framework on the part of most stock investors. This week, I will summarize the research of two well-known academics that looked at this very issue.
University of California at Davis finance professors Brad Barber and Terrance Odean published a study entitled, The Courage of Misguided Convictions, in the Nov/Dec 1999 issue of the Financial Analysts Journal. Barber and Odean studied 10,000 randomly selected discount brokerage accounts that were active in 1987. The period of study extended to 1993 and included nearly 163,000 individual stock trades covering over US$1 billion in transaction values.
Barber and Odean have written and published a number of research papers on the topic of behavioural finance.
Turnover of stock positions studied occurred at a rate of about 80 percent annually. Put another way, for every ten stocks held at the beginning of the year, eight were sold and replaced by year-end. To explain this high trading frequency, the authors propose that the common characteristic of overconfidence is to blame. It's a phenomenon that filters through all parts of our lives as noted in this excerpt from Barber and Odean's article:
".people have unrealistically positive self-evaluations (Greenwald 1980). Most individuals see themselves as better than the average person and as better than others see them (Taylor and Brown 1988). For example, when a sample of U.S. students-average age 22-assessed their own driving safety, 82 percent judged themselves to be in the top 30 percent of the group (Svenson)."
Another key finding was that this turnover saw investors sell a much higher proportion of their "winners" as compared to their "losers". In part, the paper reads:
".a stock whose value was up was more than 50 percent was more likely to be sold from day to day than a stock whose value was down. In Weber and Camerer 's (1998) experimental studies .a stock that was up was also about 50 percent more likely to be sold than one that was down."
The only exception to this was the month of December, when they found losing stocks about 20 percent more likely to be sold due to investors triggering losses for tax reasons.
Otherwise, this finding is consistent with the tendency mentioned last week, "Reference Dependence". Barber and Odean's test results were consistent with the suspicion that most investors' trading decisions are made in reference to their own individual purchase prices.
In short, investors hate to realize losses on losing stocks because it is something of an admission of failure. Even though the most highly skilled stock pickers will be wrong about 30 percent of the time, apparently unskilled stock investors cannot admit defeat on most of their losers. Hence, they let them ride until they resurface up to or above the original purchase price before selling.
Ironically, this tendency shows that investors are actually willing to take more risk when in a loss position (i.e. willing to take a chance to make their money back). Meanwhile, those same investors are much more risk averse when it comes to stocks whose prices are above original purchase price because individuals don't want to risk losing the paper profits already made.
The authors also discuss two other possibilities to explain this tendency to sell winners more often than losers.
If investors expect the tax rate on capital gains to move higher, they'll realize gains sooner (while subject to lower tax rates) and wait until higher rates apply to realize losses.
Another explanation is the possible belief by investors that all stocks revert to the mean or some other normalized price level. This ties into the common statement I hear by investors interested in a stock that has fallen dramatically over the past year. They figure it's got to go at least part way back up, so buying it now may be a bargain. It may be, but only a thorough investigation of the stock in question will reveal this.
We know, also from other parts of life, that behavioural changes just don't happen with most people. And when they do, it's a process that takes years. Hence, don't be overconfident and think that you aren't subject to such tendencies. People tend to forget or downplay their mistakes as time goes by, while simultaneously exaggerating their successes.
The key is to recognize the characteristics that we all share. Keep them in mind every time you make an investment decision. Before implementing a decision, ask yourself if your planned course of action is truly sound and based on merit, or if you're acting out of one of these common behavioural tendencies. It may not change your behaviour, but it may cause you to think twice the next time you react emotionally to investing. Awareness is the beginning of change.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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