Originally Published July 22, 2016
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 trigger happiness 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 "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 decisions just to alleviate boredom. It seems that this can spill over into investing, too.
Various research studies have suggested that excessive trading by individuals is down to the fact that trading is fun and entertaining. Essentially, it appeals to those of us who enjoy the sensation-seeking appeal of pastimes like gambling.
This matches a similar view held by Robbie Burns - the Naked Trader - who says that comfort trading like this appeals to an investor's "stubbornness." In other words, investors and traders are prone to developing a kind of tunnel vision about perhaps being invincible or being stuck in a losing trade that they are utterly sure will come right in the end. As a result, trading more (and overtrading as a result) feels like "a chance for something good to happen."
He says: "...comfort trades are really related to stubbornness. We may put them on when we're feeling low, but the positive effect we're seeking is ultimately one that satisfies our stubbornness."
Recent underperformance panics investors
A third trigger of overtrading is fear and panic. In his 1991 letter to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders, Warren Buffett noted: "Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient."
Few would argue against the fact that Buffett's buy-and-hold mentality has worked for him. Yet, faced with market mayhem, there's clearly a natural urge to do something. A classic example here (that I've borrowed from the analyst James Montier) concerns goalkeepers.
One study of top-league football matches arrived at some interesting conclusions. On average, each game saw 2.5 goals scored and the chances of a penalty hitting the back of the net was 80%. The 286 penalties taken in those games were fairly evenly targeted at either the left, centre or right of the goal. But in 94% of cases, the keeper dived left or right.
For any budding goalkeepers out there, the statistics (based on the probability matching principle) say you should stay put in the centre of the goal in about 28.7% of kicks!
What this experiment showed was something called action bias - the goalies felt compelled to take action, even though staying put was a better bet. They same theory applies to investors.
As Peter Mallouk explains in his book The 5 Mistakes Every Investor Makes, the lack of control, the idea that the portfolio is deteriorating and one can't do anything about it, causes investors to panic and sell. "This makes them feel like they're in control again. The reality is quite the opposite. The market just kicked their butts. If you do this over and over, you will lose the game."
When you look through the research into the perils of overtrading, much of the blame is placed at the door of overconfidence. It's here where researchers have really dug into the numbers and measured the impact on profits from constantly churning a portfolio. But overtrading has roots in both boredom and fear as well.
In some respects it's possible to map overtrading back to other known investor behaviour like selling winners and holding losers (the disposition effect) and loss aversion. In all of these cases, the suggestion from those that have studied this behaviour is to take a checklist approach to investing. In other words, make (and stick to) a plan of regular but well-spaced portfolio reviews and rebalancing that might help remove the compulsion to trade too often.