Don't lose the overconfidence game

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

Christine Benz: Hi, I'm Christine Benz for 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.

Video Archive...

3 top themes in Asian markets
14/02/2018  Diverse themes within financial services and renewables are among the top picks for 2018 from Nikko Asset Management's Eng-Teck Tan.
Broadly positive results from Aussie financials
08/02/2018  An assessment of the latest financial results from Commonwealth Bank, NAB, AMP and Macquarie Bank from Morningstar's David Ellis.
3 companies tipped for growth
08/02/2018  These very distinct companies across gaming, healthcare and construction are among T. Rowe Price's top Australian equity picks.
How to keep cool when the market is not
06/02/2018  Steve Wendel, Morningstar's head of behavioral sciences, offers some tips for staying rational amid market volatility.
What should you do about the market slump?
05/02/2018  The US stock market had its worst day in two years on Friday, triggering Asian and European markets to sell off too--what should investors do?
Cutting through noise on rising oil price
01/02/2018  How the Brent crude price rise to almost $70 a barrel affects Morningstar's outlook for the likes of Woodside and Santos, and have investors left it too late.
Some retailers less Amazon-exposed than others
24/01/2018  Jeff Bezos’ behemoth will continue to dominate retail news in 2018, but the short-term impact on these retailers will be muted, says Morningstar’s Johannes Faul.
What this moat upgrade means for investors
16/01/2018  Morningstar's increased moat rating for this locally-based hearing aid manufacturer and distributor reflects its shifting strategy and potential for increased service revenue, says Morningstar's Chris Kallos.
Solid dividend, earnings outlook for this utility
11/01/2018  This New Zealand utility is a top pick in the sector, but as a dual-listed entity there are some things to be aware of, says Morningstar senior equity analyst, Adrian Atkins.
Why we're bearish on aluminium prices
29/12/2017  We're forecasting a decrease in demand and think the impact of capacity cuts is being overstated.
Forecast 2018: The China opportunity, and sectors to watch
21/12/2017  These sectors and companies are tipped to perform in 2018, in part driven by the shifting relationship between Australia and China -- Part 2 of 2
Forecast 2018: A correction looms, volatility returns to global markets
21/12/2017  Global markets will likely flatten in 2018, and volatility will return, says Peter Warnes, Morningstar's head of equities research Australasia -- Part 1 of 2
Will mining shares survive a commodities slump?
20/12/2017  How have mining stocks performed in 2017? And how sensitive to underlying commodity prices are the shares?
Strong investor upside in Westfield acquisition
14/12/2017  This top-100 ASX company will be part of a retail empire worth more than $90 billion if the proposed acquisition by Unibail-Rodamco proceeds.
Inside the Tatts, Tabcorp merger
08/12/2017  With the merger of these two gaming companies close to completion, Morningstar equity analyst Daniel Ragonese looks at what this means for investors.
What Domain's Fairfax split means for investors
05/12/2017  Looking under the hood of property listings business, Domain, following its separation from Fairfax, and how Morningstar views the newly ASX-listed entity.
Royal Commission no Big 4 game-changer
04/12/2017  Government's "bank-flip" decision to pursue a Royal Commission into Australia's financial sector won't affect banks' fundamental value or our positive outlook, says Morningstar's David Ellis.
The Amazon eagle has landed
23/11/2017  As the online retail behemoth touches down in Australia, Morningstar's Johannes Faul explains what it could mean for some of your best-loved stocks
Slowdown in China's GDP growth means shift for investors
24/10/2017  We expect further pressure on China's economic outlook as sources of productivity gains continue to dry up.
2 quality stock picks from Anton Tagliaferro
23/10/2017  Investors Mutual's Anton Tagliaferro looks at a couple of quality companies which he believes boast strong competitive advantages.
Wild ride in FY17 and more to come - part 2
13/09/2017  Morningstar's Peter Warnes discusses how you may want to position your portfolio in FY18, as geopolitical storms continue to rage and safe-haven assets feel the effects.
Wild ride in FY17 and more to come - part 1
12/09/2017  Cost-out remained a dominant theme for large-cap Australian companies in FY17, and looking ahead to FY18, they should be clearer on cap-ex, says Peter Warnes, Morningstar’s head of equities research – Australasia.
Upbeat Woolies result tempered by Big W
30/08/2017  Woolworths' category-topping FY17 result driven by surprisingly strong sales, even as sector faces tougher times ahead, explains Morningstar's Johannes Faul.
Coke Amatil 1H17 result leaves margin of safety
28/08/2017  A challenged earnings announcement from Coca-Cola's Australian-listed business was largely expected, but downside is already priced in and improvements are expected in FY18.
How slashed Telstra dividend affects our outlook
23/08/2017  Brian Han remains reasonably positive on the telco giant even after some disappointments in the FY17 earnings announcement.
Earnings season FY17 mixed bag so far
18/08/2017  Aside from a few high-profile earnings guidance misses, large-cap stocks are doing okay as FY17 reporting season passes halfway, says AMP chief economist Shane Oliver.
CBA's impressive FY17 result marred by AUSTRAC case
11/08/2017  A typically clean, solid and big $9.8 billion result from Commonwealth Bank of Australia was somewhat overshadowed by ongoing coverage of its alleged role in money laundering.
Rio Tinto posts mixed result for 1H17
10/08/2017  An interim result of US$3.9 billion in net profits after tax for one of the world's largest mining companies was positive but slightly weaker than expected, even alongside a record dividend, explains Morningstar's Mat Hodge.
Kerr Neilson on why global investment exposure is key
07/08/2017  There are two types of investors, regardless of market noise, imputation credits, diversification approaches and market indices, says the managing director of Platinum Asset Management.
An interview with Westpac CEO, Brian Hartzer - Part 3
20/07/2017  Insights on Australia's housing market, China's effect on domestic banks, and cyber-security readiness, in the final instalment of Brian Hartzer's interview with Morningstar's David Ellis.
Telstra won’t be blown away by headwinds
17/07/2017  While it faces what Morningstar equity analyst Brian Han describes as a whirlwind of negatives, he suggests investors shouldn’t hang up on Telstra.
An interview with Westpac CEO, Brian Hartzer - Part 2
13/07/2017  Westpac CEO Brian Hartzer joins Morningstar banking analyst David Ellis to discuss digital disruption, regulatory change and Australian banks' social license.
The home-truths of investing
12/07/2017  Look for companies that sit outside the cycle; heed the lessons of history; and remember the power of compounding, says Bennelong's Neale Goldston-Morris.
An interview with Westpac CEO, Brian Hartzer - Part 1
06/07/2017  Brian Hartzer, CEO, Westpac joins Morningstar senior analyst David Ellis to discuss his role leading Australia's oldest bank, how Westpac can continue to grow value, and its commitment to sustainability.
Budget 2017: bank levy a potential 4pc hit to big 5 profits
10/05/2017  If unable to pass on costs associated with the new levy proposed in the Budget, bank profits and dividends could dive 4 to 5 per cent, in a significant hit to shareholders and customers.
2 leisure stocks weather Cyclone Debbie, Dreamworld fallout
02/05/2017  These two companies with large theme park operations have faced significant challenges in recent times. Morningstar senior equity analyst Brian Han explains how they've fared.
Schroders stays hot on commodities, cooler on tech and defensives
01/05/2017  Long-term investors in Australian shares will continue to find value, but the time for risk-taking on more speculative plays has passed, says Martin Conlon, Schroders’ head of Australian equities.
What lies ahead for mining and materials
10/04/2017  Iron ore, coal, lithium, and uranium: some end-markets will rise and others will fall behind, says Morningstar commodities and resources analyst David Wang.
First-half 2017 earnings season insights
15/03/2017  Companies produced reasonably good results overall with only a few standouts, even as a cost-out theme dominated, says Peter Warnes, head of equities research, Morningstar.
Earnings season wrap: BHP exercises good cost control
27/02/2017  As the curtains close on the 1H17 reporting season, BHP books earnings that are slightly softer than expected, while Woolies takes market share at the expense of margins.
Earnings season wrap: Telstra feels competitive heat
17/02/2017  As the 1H17 earnings season rolls on, Wesfarmers posts a bumper profit, Newcrest restores its interim dividend, while Telstra's profit falls as it feels the heat of intense competition.
Earnings season wrap: Rio Tinto's dividend surprises
10/02/2017  Rio Tinto delivers a surprise full-year payout of US$1.70, NAB records a soft first quarter, and CIMIC posts an annual net profit in line with Morningstar's expectations.
Xero CFO gives outlook for 2017 and beyond
02/02/2017  Sankar Narayan, chief operating and financial officer of accounting software firm Xero gives his insights on the company's business model and outlook, with Morningstar analyst Gareth James adding his views.
Shifting fortunes for ANZ, more of the same for CBA in 2017
12/01/2017  Australian banks are well-positioned as they head into 2017, with ANZ moving from least profitable in 2016 to become one of the sector's top performers and CBA remaining an investor favourite.