We frequently discuss behavioral finance on the blog and we have covered a lot of research papers on this topic. (see the archive, here). But we understand that reading a bunch of dense blogs can be tedious and time-consuming. Luckily, we sometimes run across research pieces that serve as ‘meta-analysis’ pieces, which essentially amount to studies of all the studies on a specific topic. In this particular case, we ran across a gem by Profs. Barber and Odean(1), which summarizes a lot of their life’s work (and others’) on the topic of individual investor behavior.
The authors tackle some key research questions:
The performance of individual investors.
Why do individual investors underperform?
What are the Academic Insights?
The answers to the question above are as follows:
Individual investors tend to have poor performance and this effect is robust across all research on the topic.
Why they underperform is complex, and still up to debate, but can be boiled down into the following: high transaction costs, poor security selection, and under diversification driven by overconfidence, sensation seeking, and disposition effects (and many more!)
Why does it matter?
Many market commentators, financial advisors, and professionals are quick to point that that individuals are terrible investors. Of course, it’s not exactly clear that professionals are much better than individuals, but it is certainly true that most investors should simply buy low-cost index funds (or factor funds!) and gets their hands out of the cookie jar. What’s nice about this paper is that the assertions that individuals are poor investors — and exactly why they fail to do well — are backed by peer-reviewed research. One can leverage these insights to help investors find solutions that will solve their problems and put them in a better position to be successful.
The investors who inhabit the real world and those who populate academic models are distant cousins. In theory, investors hold well-diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice, investors behave differently. They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience. Individual investors who ignore the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment.
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016).
Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.