Posts Tagged ‘percentage points’

Common Investing Mistakes to Avoid

Posted on: June 14th, 2010 by

Investments - Taxes - Education - Rockville, MDTerrance Odean, a finance professor, has spent his career studying a very specific type of investor: the one who is overconfident, shortsighted and far more likely to snap up a stock at the worst possible moment than to make the kind of contrarian bet that pays off in the long run.  Odean’s specialty: the average investor.  Odean has been studying these types of investors since the 1970’s.  Through this, he has revealed the most common investing mistakes that people tend to make.

First, he looks at overconfidence.  He says that humans seem to be hardwired to expect success and to regard themselves as above average.  In the classroom, he likes to hammer this point home by asking his students to rate their driving abilities.  “Above average” is the virtually unanimous response.  One of the few students who rated herself merely an average driver was, in fact, about to lose her license for having had three accidents in the past year.  In essence, she still rated herself higher than reality.

Odean has concluded that overconfidence permeates the ranks of investors, especially men.  Looking at the trading patterns of 35,000 households over five years, he found that single men’s confidence in their ability to outperform the market prompted them to trade 67% more frequently than did unmarried women.  The payoff for all this activity was predominately negative; the men’s portfolios underperformed those of the less-frenetic women by 1.4 percentage points per year.

Next, he looks to excessive trading.  Odean believes that trying to beat the market is a loser’s game for small investors.  He thinks the “casino” is rigged in favor of larger institutions.  Looking at every trade made on the Taiwan Stock Exchange over four years, Odean found that commissions, taxes, and poor timing of buy and sell decisions drained a collective $32 billion out of the pockets of individual investors.  The winners in the game: middlemen and institutions.  Even when the little guy thinks he’s in the know, he is often clueless about what’s going on behind the scenes.  This is not true for the big guys though.  “For an individual to not believe that he’s at an informational disadvantage when he’s trading against guys from Goldman Sachs is naive,” he says.  “It’s like deciding to play one-on-one with a professional basketball player. You’re going to lose.”

Odean compares the error of “going with the crowd” to children fighting over the same toy.  Investors are often attracted to stocks because others want them.  In fact, individuals are much more likely to buy and sell the 10% of stocks mentioned in the news and ignore the other 90%.  The problem with buying stocks when they’re popular rather than on the basis of fundamental value is that they tend to be expensive and susceptible to changes in investor sentiment.  The day after a stock ranks among top performers, two-thirds of all trades by individual investors are buys.  Over the following month these hot issues underperform the overall market by an average 1.6 percentage points.  Adding salt to the wound, Odean tells us that more often than not the stocks that investors sell outperform the ones they buy.

And finally, Odean talks about stubbornness.  Savvy investors will tend to sell “losers” to book tax losses and offset gains.  Logical as this is, few investors are willing to admit defeat.  That was Odean’s conclusion after analyzing 10,000 discount brokerage accounts over three years.  The exercise revealed that investors are more likely to sell winners and trigger capital gains taxes than to sell their losers and avoid them.

The conclusion:  If you are sure that you are in fact an above-average investor, go ahead and trade like a fiend.  But keep in mind the possibility that you are fooling yourself and would do better buying index funds and focusing on becoming a better driver.