The Lure of Trading?

Is frequent trading an essential aspect of portfolio outperformance? In their April 2000 paper entitled “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, Brad Barber and Terrance Odean examine the trading behavior and returns of retail investors. Using data for 66,465 households at a large discount brokerage firm during 1991-1996, they find that:

• After accounting for the fact that the typical household tends to invest in small value stocks, individuals underperform the market by 3.7% annually. This poor performance derives from the costs associated with a high level of trading, averaging 75% annual portfolio turnover.
• The 20% of individual investors who trade the most underperform the market by 10.3% annually.
• Excessive trading stems from investor overconfidence based on unrealistically high opinions of their private information.

In summary, a high level of trading activity usually underperforms.

The authors note that underperformance of individual overtraders is consistent with that of mutual funds with high portfolio turnover. These results tend to support the efficient markets hypothesis, which holds that truly valuable private information is rare. Thus, active investment strategies do not outperform passive ones.

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