Concerning The Performance Of Individual Investors

by: Kevin Wrotenbery


Research indicates on average, individual investors under-perform relevant benchmarks.

A deeper look at one study shows not all individual investors behave the same way.

Reducing trading frequency and avoiding risky stocks improves the performance of even an 'average' investor.

Brad Barber and Terrance Odean have written a nice, reasonably readable overview of what they describe in the abstract as "research on the stock trading behavior of individual investors". Their final sentence concludes that:

Individual investors who ignore the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment.

As an investor who holds individual stocks, I wanted to dig in to one of the often-cited papers in this area, which also happened to be authored by Barber and Odean: Trading is Hazardous to Your Wealth.

The study looked at over 66,000 account records from an unspecified discount brokerage for the six years from January 1991 through December 1996. They find that the average household -calculated weighting each household equally - had an annualized return of 18.7% before fees, and 16.4% after fees. Here, fees include commissions and estimated bid-ask spreads. A broad market index returned 17.9% for the same period. They further find that households on aggregate chose stocks with a beta slightly greater than one, which explains their pre-fee outperformance. The natural conclusion is that the average household would have been better off in an index fund.

At this point they break the accounts into quintiles based on account size - not that interesting - and then on monthly turnover. The turnover-sorted results are below.

There's a lot here. Let's start with the top row in Panel A - Monthly turnover percent. The leftmost column is for the lowest turnover group which had a monthly turnover of 0.19%, or just 2.3% annually (12 * 0.19%). This is extremely low; turnover here includes buying as well as selling. Working our way right, the annual turnover rates go to 15%, 35%, 72%, and 258% for the highest turnover group. Moving to the 'Coefficient estimate on…' (aka beta) row, we see beta is essentially 1 for the low turnover group and steadily rises as we move right, hitting 1.29 for the high turnover group. The SMB (aka size) row starts at 0.24 and also gradually increases with turnover, reaching 1.02 for the high turnover group. (For reference, WisdomTree found size factors of -0.15, 0.43, and 0.83 for the S&P 500, 400 and 600 indices respectively. So 0.24 is between large and mid-cap, and 1.02 is in micro-cap territory).

Moving to Panel B (returns before fees), let's look at the market-adjusted return - the difference between the portfolio return and the index. Every group beat the market before fees. For the low turnover group, the difference is 6.3 basis points per month, or 0.75% per year. As we move right, it generally goes up - to about 1.6% per year for the high turnover group. The higher turnover groups were buying higher-beta stocks during a very bullish era, so this makes sense. But the risk-adjusted performance - as measured by either the CAPM intercept or the Fama-French intercept, both of which attempt to measure 'alpha' - deteriorates as turnover increases, even without fees. And with fees - Panel C - it gets ugly for the average/high turnover groups, but the lowest turnover quintile achieved slightly higher returns than the index, even after fees.

The point is that the five quintiles are employing very different investment styles in ways beyond trading frequency. And it shows in the results. Champions of passive investing love to point out that 'everyone thinks they're above average'. And perhaps they do. But folks whose holdings consist primarily of medium-sized or large stocks with moderate or low betas that they've owned for a long time, have pretty substantial evidence here that they are at least different than average, and that they are different in a way that has empirically led to superior performance compared to the average investor.

The other thing worth noting is portfolio composition. I was quite surprised to read that;

On average during our sample period, the mean household holds 4.3 stocks worth $47,334…the median household holds 2.61 stocks worth $16,210.

We don't know what other assets they held - mutual funds, cash, and even ADR's were excluded - but those are very concentrated stock holdings. So if you have, say, 10 or more positions, that is another way you are decidedly different from the 'average' investor the authors conclude would be better off in a passive fund.

This certainly doesn't mean that everyone, or even most people, who adopts a buy-and-hold strategy that avoids high-risk stocks will achieve superior returns to the market. But it does suggest that if you adopt and stick to a sensible buy-and-hold less risky stocks strategy the odds are not as stacked against you as some seem to believe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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