Investors Behaving Badly: Sad but True

Thanks to a series of studies authored by Brad Barber and Terrance Odean, we have a large body of academic evidence demonstrating that U.S. investors behave badly, and that this bad behavior negatively impacts returns.

Among their findings are the following:

• Men trade 45% more than women.

• Turnover reduces net returns by 2.65% per year for men versus 1.72% per year for women.

• The turnover of single men was 67% greater than that of single women, presumably because of the lack of influence from a more cautious spouse. The increased turnover cost men 1.44% per year.

• Both men and women underperformed market and risk-adjusted benchmarks.

• The stocks that both men and women bought trailed the market after they purchased them. The stocks they sold outperformed after they were divested. Both sexes would have been better off if they simply had held the portfolios they began with.

• Investors that traded the most performed the worst.

Barber and Odean also studied the performance of U.S. investment clubs to determine if, perhaps, more heads are better than one. Here is a summary of their findings:

• The average investment club lagged a broad market index by 3.8% per year, returning 14.1% versus 17.9%.

• When performance was adjusted for exposure to the risk factors of size and value, alphas were negative even before transaction costs. After trading costs (turnover averaged 65%), the alphas were on average -4.4% per year.

• The clubs would have been far better off if they had never traded during the year. Beginning-of-the-year portfolios outperformed these clubs’ actual holdings by 3.5% per year. The reason was that the stocks they sold outperformed the stocks they purchased by more than 4% per year. The conclusion is that investment clubs have something in common with individual investors — trading is hazardous to their financial health.

The research also shows that U.S. investors do just as poorly in timing their purchases of mutual funds. Studies have found that investors manage to underperform the very funds in which they invest due to poor timing decisions — they buy after periods of strong performance and sell after periods of poor performance.

Since misery loves company, it’s nice to know that U.S. investors are not alone in their bad behaviors. Thanks to Andrew Clare and Nick Motson — authors of the study Do UK Retail Investors Buy at the Top and Sell at the Bottom? — we have evidence demonstrating that U.K. investors are equally guilty.

Clare and Motson examined the impact of timing decisions of both retail and institutional investors in the U.K. Their study covered the almost 18-year period from January 1992 through November 2009. The following is a summary of their findings:

• Just like U.S. investors (both individual and institutional), U.K. retail investors (though not institutional investors) are performance chasers. Mutual fund flows correlate with prior 12-month returns to the equity market. The correlation of fund flows and future returns was negative, though not statistically significant.

• When they looked at prior six-month returns, the correlation between market returns and fund flows increased. Unfortunately, so did the negative correlation between fund flows and future returns, and it was now statistically significant at the 99% level of confidence.

• For retail investors, the correlations were also found to be significant between the 15- and 24-month time horizons as well.

• The performance gap (the difference between returns to a buy-and-hold strategy for a fund and investor returns in that fund) for retail investors was -1.17% per year. There was also a performance gap for institutional investors, but it was smaller at -0.20%.

The bottom line is that over the 18-year period in the study, the performance-chasing behavior of U.K. retail investors cost them a total return loss of 20%.

The results of the U.K. study shouldn’t surprise us. After all, investors are human and subject to the same behavioral mistakes wherever they live. The evidence is clear: investors would be best served by following Warren Buffett’s sage advice to never try and time the market. He does add, however, that if you can’t resist that temptation, to at least be a buyer when others are panic-selling and sell when others are greedy. Instead, retail investors in both the U.S. and the U.K. tend to follow the herd, to their detriment.

Keep the results of these studies, as well as Buffett’s advice, in mind the next time you’re tempted to time the market.