Radical Guide to Investing: Measuring Stock Pickers’ Underperformance

This guide has moved, and is now The ETF Investment Guide at Seeking Alpha.com.

June 1, 2005 | Permalink


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I've read the paper mentioned, but I'm not sure YOU have.

"To put hard numbers on this: investors who pick stocks underperform the market by about 2 percentage points a year on average, according to professors Barber and Odean at the University of California at Berkley."

Brad Barber and Terrance Odean took the trading records of 66,000 customers of a major discount brokerage firm, from 1991 through 1996, accounting for more than 1.9 million trades.

They divided them into 5 groups based on frequency of trades. The most hyperactive group averaged 240% annual turnover, the most patient group averaged 2.4% turnover. All five groups beat the market index fund by about 1% annually.

However, after trading costs were accounted for, only one group beat the market - the patient group - by about 1%. The hyperactive group lagged the market by about 6.5% after trading costs.

According to Jason Zweig, other studies have confirmed that this occurs with institutional traders, as well.

The point of the paper was PATIENCE and minimizing expenses. However, as a commentary on stock-picking, the paper actually points out that ALL FIVE groups did a good job of beating the index.

The point is, don't confuse your point. That paper is an indictment of hyperactive trading's impact on expenses, not an indictment of stock picking. The 1/5 of investors with low turnover generated alpha by picking their own stocks.

Posted by: Bill R. | Jun 9, 2005 11:04:11 AM


The abstract from the Barber-Odean paper states:

"Individual investors who hold common stocks directly pay a tremendous performance penalty for active trading. Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. 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."

They also write:
"the net returns earned by the average household lag reasonable benchmarks by economically and statistically significant amounts; the average household earned an annualized geometric mean net return of 15.3 per cent", compared to the index performance of 17.7%.

That data on the returns of *the average household* is the basis for the statement "investors who pick stocks underperform the market by about 2 percentage points a year on average". I rounded down Barber and Odean's number for the average household which was in fact underperformance of 2.4%.

The key proposition of the paper was that individual investors suffer from overconfidence, and that leads them to trade excessively. It is exactly that overconfidence in individuals' stock picking ability, net of trading fees and taxes ("after you paid taxes and fees"), that I was addressing in this chapter.

Your point, however, is that excluding taxes and fees individual investors do indeed generate alpha, proving that they are good stock pickers. But Barber and Odean also pointed out that retail investors favor high beta small cap stocks, and that probably explains why many of them beat the market-cap-weighted index during the sample period:

"the tilt of households toward small stocks and, to a lesser extent, value stocks helps their performance during our sample period (during which small stocks outperform large stocks by 15 basis points per month and value outperforms growth by 20 basis points per month)"

It doesn't seem valid to conclude from that that individual investors are good stock pickers, or (in your words) that all five groups "did a good job of beating the index".

In fact, Barber and Odean list three (secondary) conclusions from their research:
1. Households trade common stocks frequently.
2. Trading costs are high.
3. Households tilt their investments toward small, high-beta stocks.

They also add (near the end of the paper):
"In short, the results in the main text overestimate the performance of individual investors by ignoring the exact timing of purchases and sales."

Finally, note that Barber and Odean's results exclude the impact of taxes. Even with 2.4% turnover, matching the market on a pre-tax basis would lead to underperformance on a post-tax basis.

The URL for the paper (abstract and link to PDF) is here:

and a complete list of Prof Odean's papers is here:

Posted by: David Jackson | Jun 10, 2005 1:26:05 AM

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