Academic Paper Review: "The Behavior of Individual Investors"

A key pillar of Invariant’s investment philosophy is that “Behavioral mistakes can derail even the best investment plans and strategies.” Recently, I came across an academic paper on the topic by Brad M. Barber and Terrance Odean written in 2013 called “The Behavior of Individual Investors.” The authors review studies that document the different types of behavioral mistakes that individual investors (and sometimes, professional investors) make that ultimately detract from their long-term performance. Academic papers can be notoriously difficult to comprehend, so the primary objective of this post is to distill the content into a few key concepts, helping readers understand these concepts and hopefully avoid the most common pitfalls of individual investors.

Introduction

The paper begins by outlining assumptions of traditional finance models (such as the Capital Asset Pricing Model – CAPM) that do not stand up to further scrutiny when we examine the behavior of individual investors. The models, in general, assume that individual investors “carefully assess the risk and return of all possible investment options to arrive at an investment portfolio that suits their risk aversion” and “hold well-diversified portfolios consisting of the market portfolio and risk-free investments.” More simply stated, they assume that investors hold a globally diversified, market capitalization weighted portfolio adjusted for their desired willingness and ability to take risk. The body of empirical research on the subject suggests that reality does not comport with these assumptions – individual investors in aggregate hold under diversified portfolio and trade “actively, speculatively, and to their detriment”. These contradictions are the drivers of individual investor underperformance.

The authors then examine the magnitude of individual investor underperformance over various time horizons, citing a litany of studies that all reach the same conclusion – those individual investors underperform. For example, “Barber and Odean (2000) sort households into quintiles based on their monthly turnover from 1991 to 1996. The total sample consists of about 65,000 investors, so each quintile represents about 13,000 households. The 20% of investors who trade most actively earn an annual return net of trading costs of 11.4%. Buy-and-hold investors (i.e., the 20% who trade least actively) earn 18.5% net of costs. The spread in returns is an economically large 7 percentage points (pps) per year” (Barber and Odean 2013). They go on to provide examples of the same conclusion reached in more than 20 studies. While the conclusion of this section is well understood and uncontroversial, understanding the drivers of this underperformance is much more useful and interesting.

Common Individual Investor Pitfalls

Overtrading

Trading on its own is not a behavioral error. Rebalancing, liquidity needs, and tax management are all valid reasons for an individual investor to trade. Depending on their beliefs about market efficiency, professional investors may adjust portfolio exposure as the outlook for different asset classes and securities changes.

These legitimate reasons to trade do not explain the annual turnover rates we see in individual investors portfolios. “It is, however, difficult to reconcile non-speculative trading needs with the annual turnover rates of 250% for the 20% most active investors in the LDB dataset (Barber and Odean, 2000), annual turnover of 300% in Taiwan (Barber et al., 2009), or annual turnover of 500% in China (Gao, 2002).”

Excessive trading comes with costs – transaction costs (including bid/ask spreads) and tax consequences. Additionally, individual investors in aggregate underperform before these costs are considered as they do not possess stock-picking skills on average.

Failure to Diversify

Nobel Prize laureate Harry Markowitz said, “Diversification is the only free lunch in investing.” In the review of the literature, many investors fail to take advantage of the full benefits of diversifica­tion. Examples may include overinvesting in company stock, famil­iar stocks, and domestic companies. Doing so may make them feel safe, but it leaves them exposed to increased volatility in their investment returns.

To read more about the benefits of diversification, check out our blog post “A Primer On Asset Allocation.”

Media Influence

Barber and Odean make the case that individuals do not have sufficient time to devote to investing and are often influenced by media coverage. In their 2008 paper, the authors “argue that attention greatly influences individual investor purchase decisions. Investors face a huge search problem when choosing stocks to buy. Rather than searching systematically, many investors may consider only stocks that first catch their attention (e.g., stocks that are in the news, or stocks with large price moves). This will lead individual investors to buy attention-grabbing stocks heavily, leading to potential future underperformance.

To read more about the dangers of performance chasing, check out our blog post “Behavioral Mistakes Can Derail Even the Best Investment Plans.”

The Bottom Line

In theory, individual investors hold diversified portfolios and only trade to rebalance or “tax-loss harvest.” However, reality does not match theory - Individual investors trade frequently, do not possess the ability to add value via stock-picking, hold poorly diversified portfolios, and their trading actions are influenced by the media. By becoming conscious of these potential behavioral errors, investors can improve their self-awareness and aim to avoid these behaviors, or even hire a professional to help them navigate these potential issues and achieve long term success.