This is the second installment of Investor Behavior. To remind you of the origin: The purpose of this post is to share with you what I considered some interesting information about individual investors. The paper is from
Advances in Behavioral Finance, Vol II, Russell Sage Foundations/Princeton University Press, 2005.
The paper is Chapter 15 of the aforementioned book and is titled, "Individual Investors", its authors, Brad M. Barber and Terrance Odean. If this is a subject that interests you, though the paper is not listed at this following
link, several other papers are listed that you might find interesting. In this paper, the authors examine "The Disposition Effect" (explained below) and investors' tendencies to trade to frequently due to overconfidence.
Regarding Investor Overconfidence, you must understand that this is a universal phenomena--it's endemic to our humanness (just like all of the children in Lake Wobegon are above average). Studies by several different folks have shown that "people tend to overestimate the precision of their knowledge" and that this has been found in many professional fields: physicians, nurses, investment bankers, engineers, entrepreneurs, lawyers, negotiators, and managers. How is this tested? Through . . . studies of the calibration of subjective probabilities. (p. 554). Here are some of the additional manifestations (in addition to the miscalibration) of that overconfidence as people tend to :
"(All taken from pp 554-555)
- overestimate their ability to do well on tasks, and these overestimates increase with the personal importance of the task (Frank 1935);
- have unrealistically positive self-evaluations;
- are unrealistically optimistic about future events;
- expect good things to happen to them more often than to their peers;
- see themselves better than the average person and see them selves better than others see them;
- rate their abilities and their prospects higher than those of their peers;
- overestimate their own contributions to past positive outcomes, recalling information related to their successes more easily than that related to failures;
- 'misremember thier own prediction so as to exaggerate in hindsight what they knew in foresight.' (Fischhof 1982);"
The authors state that "These beliefs can also lead to biased judgments." Now, if you FAIL to see how any of this applies to you then you have only confirmed everything that the these researchers have found through empirism. However, if you see how this applies to you and have a sting of shame upon your cheeks, then you are well on your way to creating better self awareness!
Naturally since this phenomena shows up in every aspect of our life, it is reasonable to expect that it will show up in its full glory in our investing behavior. The authors make a useful distinction regarding "information" that a trader/investor receives. And their emphasis is on "informed" traders. First, let's look at the authors' premise:
"In a market with transaction costs, we would expect informed traders who trade for the purpose of increasing returns to increase returns, on average, by at least enough to cover transaction costs. That is, over the appropriated horizon, the securities these traders buy will outperform the ones they sell by at least enough to pay the costs of trading." (P. 555)
It's worth noting that transaction cost these days are significantly less than those of when many of these studies were conducted. It will be interesting to see additional, more contemporary studies, that perhaps revisit some of these concepts and see if there if transactions cost reduce, magnify or have no effect on these outcomes. Now let's take a look at "information". Traders can be mistaken (overconfident) in
- the precision of the information that they have
- their ability to interpret information
The authors state that overconfidence in the information itself generally does not lead to losses beyond transaction costs. However, if they are overconfident in both the precision of the information and their ability to interpret that information, "they may incur average trading losses beyond transaction costs." (p. 555)
To tie this is with our disposition effect, the authors note "If they unwittingly misinterpret information, they may choose to buy or sell securities that they would not have otherwise bought or sold. They may even buy securities that, on average and before transaction costs, underperform the ones they sell." (p. 555).
I don't know about you, but reading the above gave me substantial pause. What would be helpful to any of us as investors is to know (1) how precise the information is that we know; (2) how uniformly understood is this information--naturally if it is widely understood, then it should already be priced in; and (3) how capable we are to even evaluate such information.
The authors then note that overconfidence leads to overtrading. "Odean (1998b) predicts that the more overconfident investors are, the more they will trade and the more they will thereby lower their expected utilities. . . . we would expect that, on average, those investors who trade most actively will reduce their returns through trading... . we find that this is the case." (p. 559).
Now here is the provocative, gender stuff! "While both men and women exhibit overconfidence, men are generally more overconfident than women". (p. 560). I'm sure that will not surprise any female readers and I say that with apologies to male and female readers alike. This is also an area where the studies are a bit older (1977, 1997), but it appears that it has at least been validated by more contemporary studies. Here are a few of the gender differences that you might find interesting:
"(quoted/paraphrased)from pp 560-561)
- differences in confidence are highly task dependent and are greatest for tasks perceived to be in the masculine domain
- per Deaux/Farris (1977) "overall, men claim moreability than do woemen, but htis dfference emerges most strongly on . . . masculine task(s)".
- men are inclined to feel more competent than women do in financial matters
- gender differences in self confidence depend on the lack of clear and unambiguous feedback. When feedback is 'unequivocal and immediately available, women do not make lower ability estimates than men. However, when such feedback is absent or ambiguous, women seem to have lower opinions of their abilities and often do underestimate relative to men." (Lenny 1977)
Based on the literature survey in addition to the authors' original research they posit: "We expect men, the more overconfident group, to trade more atviely than women and, in doing so, to detract from their net return performance more." (p. 561) In fact, they note (p. 561) that
- Men trader 45% more than women
- Men reduce their returns through trady by 0.94 percentage points more than women
- Men underperfom their "buy and hold" portfolios by 2.652 percentage points annually; women underperform by 1.716 percentage points.
{you can read more about gender differences in the following:
BOYS WILL BE BOYS: GENDER, OVERCONFIDENCE, AND COMMON STOCK INVESTMENT*
BRAD M. BARBER AND TERRANCE ODEAN}
Buying V. Selling: The authors make an obvious but important distinction about the differences in behavior in buying v. selling stocks. The obvious point is this: When buying a stock, the universe is pretty large, but when selling a stock you can only sell what you own. The authors note that less than 1% of investors sell short--so their analysis is based only on stocks held long and available to sell.
So given this large universe from which to buy, how do investors do it? The authors note that "investors tend to be net purchasers of attention grabbing stocks, even when it is bad news that catches their attention."
Moreover, the authors note that with the advent of the Internet, and seemingly limitless information, this access to information actually increases investor overconfidence "by providing an illusion of knowledge and an illusion of control" (P. 562) (and let's not forget that systematic bias that some may have in processing that information!!!!). They go on to state supporting studies which distill down to this important point:
"additional information can lead to an illusion of knowledge."
Accordingly, investors think that they have more control and trade to often and more speculatively. (p. 563).
IN conclusion, the authors make this perspicacious observation:
"The investor behaviors discussed in this chapter have the potential to influence asset prices. The tendency to refrain from selling losing investments may, for example, slow the rate at which negative news is translated into price". The obverse is of course that "the tend3ency to buy stocks with recent extreme performance could cause recent winners to overshoot."
I'd like to introduce you to a
website that has many of Brad M. Barber's published papers.
I hope that you found this discussion interesting. I would encourage you to study more about investor behavior. People who understand YOUR foibles better than you do can take advantage of that in the marketplace. And shaking our own biases is like trying to change our spots. But at least knowing that we have spots--I call that self-awareness--is a good place to start.
Thank you for taking time to stop by.
Yes, this is a bird-dog post! I wanted to introduce you to the following study which I believe has interesting implications for those of you who are regular readers of research reports. I found this paper, "Buys, Holds, and Sells: The Distribution of Investment Banks' Stock Ratings and the Implications for the Profitability of Analysts' Recommendations" (September 2005), at Brad Barber's research page.
The redistribution is remarkable, is it not?
