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How retail investors are their own worst enemies

  • Communications
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  • Oct 2, 2017
How retail investors are their own worst enemies

Professor Terrance Odean

A lifetime of studying investor behaviour has convinced Professor Terrance (Terry) Odean that retail investors are their own worst enemies.

As a leading Finance researcher at UC Berkeley’s Haas School of Business, Odean has dedicated his career to exploring the mistakes made by individual investors and the thinking behind these mistakes. He shared insights with an audience of Ivey alumni, finance professionals, and retail investors at Ivey’s Tangerine Lecture in Finance in Toronto on September 14.

Odean began his talk by identifying five investor biases:

  • Confusion about probability leads to undiversified portfolios that are too risky;

  • Overconfidence in their ability leads investors to trade too frequently, increasing costs;

  • Desire to reduce regret leads investors to hold on to losing investments, worsening the result;

  • Limited attention leads investors to buy stocks that are in the news after they have run up in price; and,

  • Confusion about probability leads investors to chase performance and buy last year’s winners, only to see them revert to mean performance.

Odean spent the rest of his talk explaining the rationale behind these biases and the outcome for investor portfolios. Here are some takeaways:

Probability matters

Investing involves more than just numbers, you also have to understand probability. But Odean said investors often use mental shortcuts, or heuristics, to deal with probability.

“Investors say to themselves: how likely is this to be successful? They think about how often these things fail. If failures don’t come to mind easily, they’re likely to overestimate the probability that this is going to be a success,” he said.

To overcome this, Odean said investors might consider getting training in probability assessment or should at least keep in mind that their assessments likely contain biases.

Overconfidence overlooked

Odean once asked his students to rate how good they drive compared to others in the class. All the students rated themselves above average – a clear statistical fallacy. He explained that people often think they perform better than they do. Investors, too, think they have more ability to beat the markets.

“They trade more because they think they know more than they do. They trade less because they don’t know more than they do. They underdiversify because, when you’re sure you’re right, why hedge? And then the market volatility goes up,” he said.

Attention influences

When there are thousands of stocks to buy, how do you choose? Odean said investors typically choose from about 10-12 stocks that are getting the most attention headlines in the news. On the flip side, when there is a lot going on in their lives or in the market, investors may not pay enough attention to what they are buying.

“The market as a whole underreacts to earnings announcements when there are a lot of announcements on the same day or when the announcements come out on a Friday afternoon and you’re thinking about what you want to do on the weekend or when there are other things going on that grab your attention,” he said.

Odean said studies show investors pay more attention to a stock’s performance than anything else and overlook other important criteria, such as fees.

So what can investors do?

As a result of these behaviours, Odean said the stocks held by retail investors typically underperform the ones they sell.  He shared five tips for reversing this trend:

  1. Invest for the long run;
  2. Buy and hold;
  3. Diversify;
  4. Keep your investment costs and fees down; and,
  5. Pay attention to taxes.

“Instead of saying individuals should always do the opposite of what they feel like doing, I’m going to suggest a conservative approach to investing. It may seem like a boring approach, but it works,” he said.

The Tangerine Lecture in Finance series, sponsored by Tangerine Bank, aims to highlight thought-provoking and practical information about the world of finance. It is organized each year by the Tangerine Chair at Ivey, currently Associate Finance Professor Michael King. If you have a topic that you would like to see profiled, please email him at mking@ivey.ca.