Finance prof says investors are their own worst enemies.
Investing of any kind brings with it both inherent risk and opportunity. But for Terrance Odean do-it-yourself investing has always been something he’s generally counseled against. Odean is an Associate Professor of finance at the Haas School of Business at the University of California, Berkeley. I have seen him speak a few times in the past and found his presentations thought-provoking and entertaining – so I jumped at the chance to hear him again when he spoke at the Morningstar Investment Conference in Toronto on Wednesday.
Odean was speaking to an audience of professional financial advisors who I’m sure lapped up his research-based conclusions on why investors are their own worst enemies – which was the actual title of his presentation. Now before you get too worked up about some academic telling you that you’d be better off working with a quality financial advisor, let’s have a look at some of his arguments and see if any of it strikes you as consistent with your own behaviour.
In his presentation Odean outlined five key biases that he says doom those who go it alone. He says investor confusion about probability leads them to under-diversify, overconfidence leads them to trade too much, their desire to reduce regret leads them to cling to losers, limited attention leads them to buy attention-grabbing stocks – and finally, returning to confusion about probability, he argues it also leads investors to chase performance. Further into his presentation, Odean threw up a slide highlighting research he published in 2000 that shows investors who move to online trading tend to accelerate their trading, trade more speculatively after going online, and perform poorly relative to before they went online.
Knowing that – for many Stockhouse users, Odean’s presentation constitutes a direct challenge – I ducked backstage to speak with him following his presentation. Here’s the bulk of that brief interview:
Darin Diehl: Do you equate do-it-yourself investing with frequent trading?
Terrance Odean: There are do-it-yourself investors who are taking a long-term view of things. What I’m advocating is that most investors start at the baseline with a view that smart investing is long horizon, buy and hold, and diversified and that people avoid extremely active trading. Whether you need advice or not – well some people clearly benefit from advice and some people don’t need advice. There’s also a lot of ways to get advice. I’m not saying that individual investors can’t study stocks and make good investments. I’m sure there are some that do. But in general I discourage people from doing it because it’s more often that they hurt themselves than they don’t. The average investor out there is going to benefit from trading less actively. And the average investor is not going to have either the time or the skills to compete with the professional investors.
DD: Do you think people underestimate the time factor to do proper due diligence?
TO: I used to use this example with my students. Suppose there were a dentist and he had one million dollars in indexed funds. And he figured out he could beat the market every year by one percentage point. But he also realized he couldn’t do it part time. So would it make sense for him to quit his job and spend his time running his portfolio? And if you run the numbers you can see clearly it doesn’t. A lot of people may have the intelligence and the ability to learn how to trade and understand markets, but to think you can do this part time when the professional investors are devoting vast resources is a little overconfident.
DD: But many do-it-yourself investors aren’t necessarily trading on their entire pool of assets – it’s often some percentage of their overall portfolio.
TO: If you really enjoy trading, that’s fine. But what I would recommend is set aside 90% of your money and put it into a well-diversified portfolio. Take 10% of your money and have some fun. You can take some bigger risks with it. You can afford to speculate.
DD: Today’s investor, whether they work with an advisor or not, does seem to be more educated, more engaged in the process. Do you agree that’s a good thing?
TO: I think it’s good for investors to educate themselves. But in educating yourself, I would hope that that doesn’t mean you would decide that you should become a very active investor. I have spent much of the last 20 years educating myself about finance, I have my PhD, but I don’t trade actively at all. Before I studied finance I used to trade very actively. So, one of the effects of my education was to slow down my trading activity.
DD: Still, others with an understanding of the risks and rewards might still choose to go it alone.
TO: People can make informed choices. People can be very aware of the research that I’m doing but decide they think they can do better on their own and are willing to take the risk and perhaps enjoy investing on their own. My dad belongs to an investment club and enjoys it greatly and I don’t discourage him from that. But the money he’s investing is not their retirement funds – it is money he can afford to lose if things go wrong.
As we wrapped up our conversation, Odean again acknowledged that the due diligence process, especially in the area of smaller stocks, can indeed be engaging for individual investors. “I definitely see how it can be fun,” he said. “But I would hope that people who are enjoying it are also being clear with themselves about their motivations and what they’re doing.”
If you’d like to learn more about Terrance Odean’s research check out his website: www.odean.org
Darin Diehl
Publisher, Executive Editor
Stockhouse
