Don't lose the overconfidence game

Christine Benz  |  22/03/2016Text size  Decrease  Increase  |  

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here at the Morningstar Institutional Conference. One of the key behavioural forces that affects investors' financial decision-making is overconfidence. Joining me to discuss that topic is Terry Odean. He is a finance professor at UC Berkeley.

Terry, thank you so much for being here.

Terry Odean: Happy to be here. Thank you.

Benz: Let's discuss one of the big behavioural mistakes that we hear investors make. This is one that you've done research on, the idea that investors can get overconfident. First, let's discuss that phenomenon in general. Why does it happen that investors become overconfident?

Odean: Overconfidence is common in general life, and in fact a little bit of overconfidence isn't such a bad thing. People who are mildly overconfident are happier getting up in the morning. A little optimism also doesn't hurt people. People who are mildly optimistic enjoy going to work more. They expect things to succeed.

Investing is an area, though, where too much overconfidence leads people to trade more than they would have otherwise, and more often than not, earn less in their returns than they would have otherwise.

There are a few things going on there. One, the overconfidence is basically this idea that you think you know more than you do, which is quite common with investors. Investors oftentimes don't understand that when one investor buys a stock on the New York Stock Exchange or Nasdaq, some other investor is selling a stock. And in the US, at least, when an individual investor buys a stock, more likely than not the person selling it is an institutional investor. Maybe the individual investor is a smart guy, but he is a smart guy often trying to do investment research part time--comes home from work, reads a little bit, and makes a trade. The person on the other side of the trade is probably sitting in a very tall building in southern Manhattan, has a research support team, is doing this for a living, and has access to information like this. It takes a certain amount of hubris to think that you can beat professionals at their own game when you are only a part-time player.

Benz: One devil's advocate point for the small investor is that the small investor may be able to take a longer time horizon with individual stocks. The professional money manager may be held accountable by each quarter's performance or maybe each year's performance, but the individual investor can be a little more patient. Do you think that's a potential benefit that would accrue to the smaller investor?

Odean: I think there is a benefit to being patient. Whether the smaller investor is patient is going to vary from investor to investor. There are obviously patient institutional investors, too. Your value investors tend to have long horizons, and Warren Buffett is famous for his long horizons.

So, while there are undoubtedly institutional investors who are forced to answer to short horizons, I don't think it's a huge advantage for the individuals, and a lot of individual investors who become active traders are impatient, even though perhaps they don't have to be impatient.

But in general, patience is a good thing.

Benz: Back to overconfidence--you did some groundbreaking research roughly 15 years ago or so where you looked at gender differences in terms of investing behaviour, and one of the areas that you looked at was this idea of overconfidence and how it manifests itself in more rapid-fire trading, specifically among males.

Odean: To step back a little further, I actually wrote a theoretical paper about what would happen in markets if investors were overconfident, if they thought they knew more than they did. The implications were they would trade more than they would have otherwise. It's going to hurt their returns. Markets get more volatile. And actually investors under-diversify because, when you are sure you're right, there is no need to hedge.

I wanted to test this, so I was able to get trading records for individual investors. We don't know exactly how much people should trade, but a reasonable metric would be, when you sell one stock and buy another that on average the stock that you buy goes on to outperform the one you sold, and preferably you buy enough to cover the transaction costs.

To my surprise I found that what I thought I was going to find when I did the study--which is that the stocks people bought did about as well as the ones that they sold, but that they lost the transaction costs in the process ... What I found actually was the stocks individuals bought on average went on to underperform the ones they sold. So, that was my first look at actuals.

Then my colleague Brad Barber and I did a study. We took this one step further. The theory is that overconfident investors will trade more and that this is going to hurt their returns. Let's see whether people who are trading more are earning more or earning less. We looked at about 60,000 investors, and we separated them into five groups based on how actively they were trading. The average net return, net of commissions and spreads, the average net return to the most active investors was about 6 or 7 percentage points a year below that of the buy-and-hold investors. We titled that paper, Trading is Hazardous to your Wealth.

Then we thought, really what you'd like to do in order to show that overconfidence is leading people to trade more, and as a result earn less, would be to get a large sample of investors and to separate them into the more-overconfident and the less-overconfident ones. Then you have a prediction: more-overconfident investors are going to trade more and that should hurt their returns--or at least that's the prediction.

Well, we didn't have any way to survey 60,000 investors and administer the psychological tests of overconfidence, but we came up with a proxy for overconfidence based on the psychology literature, and also a little bit of anecdotal observation. It appears that men and women differ in their average level of overconfidence, and what comes as a surprise to some people is that it's actually men who are more confident, particularly in areas such as finance and things related to math.

So, we thought, we are going to separate our sample of about 30,000 investors. We knew whether the account had been opened by a man or a woman. We could separate them into men and women, and our prediction is that men will trade more, and that's going to hurt their return. And we found that men traded about 45 per cent more actively than women. Single men traded 67 per cent more actively than single women.

Then we measured the effect of trading on returns by looking at what each account had, what was held in the portfolio, at the beginning of the year. We calculated what that account would have earned that year if there had been no trading, just buy and hold, based on what was there. Then we calculated what the account actually earned.

Now, given what I told you a moment ago, it's not surprising to find out that both men and women underperformed the buy-and-hold approach, but men underperformed by 1 percentage point more a year than women, and single men underperformed by 1.4 percentage points more a year than single women.

Something to bear in mind: I once had a reporter say, who cares about a percentage point? Everyone should care about a percentage point. Next time you take out a mortgage, and someone says, we could give you a 30-year mortgage at 5 per cent or 4 per cent; it really doesn't matter. Go elsewhere.

Benz: It matters.

Odean: It does matter. It matters a lot.

Benz: Those sums add up over time. The question is, for individual investors who are aware of this phenomenon, who know that overconfidence could be a factor that could negatively impact their financial decision-making, what steps can they take? Is there anything they can build into their process to help ward against overconfidence? Obviously, trading less is something they should try to incorporate. Any other tips you can give?

Odean: Most individual investors should be buying well-diversified, low-cost mutual funds. Now, if you really enjoy trading, then admit to yourself: I'm trading, and I'm trading because I enjoy trading. And ask yourself, what can I afford? How much of my money can I afford to play with? Maybe 10 per cent and put 90 per cent in buy-and-hold, well-diversified, low-cost funds. When I say mutual funds, I'm talking about open-end mutual funds or exchange-traded funds.

Benz: The vanilla types ...

Odean: Yes. I'm more concerned about making sure it's really well-diversified and pay attention to fees.

And then you can play. Now, if you want to be smarter, learn some accounting and do some reading and do some research. Read Danny Kahneman's book about Thinking, Fast and Slow, and you'll learn all about the biases that we all have, including Danny, and among them are things like confirmation bias. We have a strong tendency that once we have an idea: This is a great stock. Now you look for reasons why you are right. What you should be looking for are reasons why you are wrong. And if you look really hard for why you are wrong, and you can't find it, you can't see why I'm wrong, then that's a better position from which to proceed than just going around, looking for things that confirm what you already believed to be true. So, there are things you can do, but really most investors shouldn't be out there trying to beat the professional investors.

Benz: Terry, thank you so much for being here. Thanks for your insights.

Odean: You're welcome. Happy to be here. Thank you.

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04/07/2013  --
What to expect in 2014
26/06/2013  Huntleys' Your Money Weekly will shortly release its rolling six-month forecast and Morningstar's Peter Warnes gives investors an idea of what to expect as we head into the 2014 financial year.
The future News Corp
24/06/2013  Morningstar's Michael Corty looks at investor implications following the recent split of News Corp.
QBE Insurance poised for growth
11/06/2013  QBE is coming up on the halfway mark of its financial year and there are a number of external factors that bode well for the insurer, according to Morningstar's David Ellis.
Searching for sustainable dividends
03/06/2013  At the 2013 Morningstar SMSF Trustee Strategy Day in Sydney, Peter Warnes helps investors separate the wheat from the chaff when it comes to high-yielding equities.
Choosing high-quality companies
24/05/2013  Morningstar’s Mathew Hodge provides insights into what makes a business valuable for the long-term.
ASX and the retail investor
10/05/2013  ASX chief executive Elmer Funke Kupper talks about the market outlook, listed bonds, and why retail investor confidence is everything.
Can ANZ sustain its dividends?
09/05/2013  ANZ deputy chief executive Graham Hodges discusses the bank's recent dividend increase and its growth initiatives
BHP and Rio head to head
19/04/2013  After the big two miners released their quarterly production numbers earlier this week, Morningstar's Mark Taylor give investors an idea of which company put in the best performance.
A closer look at an outperforming LIC
17/04/2013  WAM’s Geoff Wilson provides an insight into the type of companies that have driven performance for the listed investment company.
Woolworths versus Wesfarmers
12/04/2013  With Woolies having released its quarterly sales and Wesfarmers set to announce its figures next week, Morningstar lets investors know how these companies are faring as we head towards the end of fiscal 2013.
Is NAB set for a turnaround?
11/03/2013  National Australia Bank is set to surprise investors with strong earnings growth, signalling a turnaround for the bank.
Paying dividends in gold
08/03/2013  Evolution Mining's Jake Klein talks about the company's new dividend policy that aims to give investors greater exposure to the production of gold.
Top stocks from earnings season
01/03/2013  As the curtains are drawn across the half-year earnings season, Morningstar's Peter Warnes helps shed some light on what can often be a confusing time for investors.
Earnings season winners and losers
15/02/2013  For the week ending 15 February, Morningstar head of equities research Peter Warnes lets investors know which companies' earnings impressed and which did not.
Earnings season winners and losers
08/02/2013  For the week ending 8 February, Morningstar head of equities research Peter Warnes lets investors know which companies' earnings impressed and which did not.
Banks and financials outlook 2013
20/12/2012  Morningstar's David Ellis tells investors what issues to keep an eye on and gives them an idea of what to expect in terms of earnings from the financials sector in 2013.
Consumer, health and industrials in 2013
21/12/2012  Morningstar's Peter Rae lets investors know what to expect from the consumer, healthcare, industrials and telco sectors in the coming year.
Huntleys' 2013 forecast
07/12/2012  Morningstar’s head of equities research Peter Warnes provides an outlook on the key investment issues for 2013.
Is the IMF wrong on banks?
22/11/2012  The International Monetary Fund has called for greater capital controls in Australia's banking sector but are their concerns justified?
Westpac full-year earnings snapshot
05/11/2012  Westpac has delivered pleasing earnings and dividends for fiscal 2012 and Morningstar's David Ellis lets investors know what he expects from the bank down the track.
NAB full-year earnings snapshot
31/10/2012  Morningstar's David Ellis gives investors a breakdown of NAB's fiscal 2012 earnings and also discusses the bank's beleaguered UK operations.
ANZ full-year earnings snapshot
25/10/2012  Morningstar’s David Ellis gives a rundown of ANZ's fiscal 2012 earnings and gives investors an idea of what to expect from the bank in terms of capital management.
Investing in Suncorp CPS2
12/10/2012  Morningstar provides investors with its insights into the latest hybrids issue from Suncorp Group.