Earlier this year I explored the risks of taking too much confidence from too much information and not always making better investment decisions as a result. It’s not that a wealth of information and research is a bad thing (and neither is confidence) - far from it. Rather, there’s a risk that being overconfident can end in all sorts of damaging investing behaviour like overtrading, overoptimism and under diversifying.
Of all these investing pitfalls, overtrading is a particularly thorny issue (although all of them are dangerous). Evidence shows that too much trading racks up high dealing fees and damages profits. But overtrading isn’t just something that can be blamed on overconfidence. In fact, the temptation to be trigger happy with the buy and sell button can be caused by a need for excitement and even follow a bout of poor performance.
Overconfidence leads to overtrading
In joining the dots between human emotion and overtrading, let’s first pick up on the most common associated flaw - overconfidence. Research on this topic is extensive. Back in 2000, a study by two influential behavioural finance experts called Brad Barber and Terry Odean, made some interesting findings.
They dug into the trading accounts of around 66,500 households at a large US discount broker between 1991 and 1996. Those years happened to be pretty good for US markets, with the average return being 17.9%. Yet those that traded most during that period (the top 20%) only managed an annual return of 11.4%. On top of that, the average annual turnover in their portfolios was more than 250%.
The average household in the research managed an annual return of 16.4% and turned over 75% of its portfolio. That left Barber and Odean in no doubt about what the findings showed. They drew a direct link between overtrading and investors who think they are better-than-average and overestimate their own stock picking abilities.
They concluded: “Overconfidence can explain high trading levels and the resulting poor performance of individual investors. Our central message is that trading is hazardous to your wealth.”
Boredom lulls us into comfort trading
Nobel Prize winning economist Paul Samuelson, once said that investing should be dull, and more like more like “watching paint dry or grass grow”.
Unfortunately, there’s evidence of the opposite happening in some cases. Among day traders, for example, there’s a well known tendency to make rash trading…
