Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors

Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors BRAD M. BARBER and TERRANCE ODEAN* ABSTRACT Individual investors who hold common stocks directly pay a tremendous perfor- mance 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. The investor’s chief problem—and even his worst enemy—is likely to be himself. Benjamin Graham In 1996, approximately 47 percent of equity investments in the United States were held directly by households, 23 percent by pension funds, and 14 per- cent by mutual funds ~Securities Industry Fact Book, 1997!. Financial econ- omists have extensively analyzed the return performance of equities managed by mutual funds. There is also a fair amount of research on the performance of equities managed by pension funds. Unfortunately, there is little research on the return performance of equities held directly by households, despite their large ownership of equities. * Graduate School of Management, University of California, Davis. We are grateful to the discount brokerage firm that provided us with the data for this study. We appreciate the com- ments of Christopher Barry, George Bittlingmayer, Eugene Fama, Ken French, Laurie Krig- man, Bing Liang, John Nofsinger, Srinivasan Rangan, Mark Rubinstein, René Stulz ~the editor!, Avanidhar Subrahmanyam, Kent Womack, Jason Zweig, two anonymous reviewers, seminar participants at the American Finance Association Meetings ~New York, 1999!, the 9th Annual Conference on Financial Economics and Accountancy at New York University, Notre Dame Uni- versity, the University of Illinois, and participants in the Compuserve Investor Forum. All errors are our own. THE JOURNAL OF FINANCE • VOL. LV, NO. 2 • APRIL 2000 773 In this paper, we attempt to shed light on the investment performance of common stocks held directly by households. To do so, we analyze a unique data set that consists of position statements and trading activity for 78,000 households at a large discount brokerage firm over a six-year period ending in January 1997. Our analyses also allow us to test two competing theories of trading ac- tivity. Using a rational expectation framework, Grossman and Stiglitz ~1980! argue that investors will trade when the marginal benefit of doing so is equal to or exceeds the marginal cost of the trade. In contrast Odean~1998b!, Gervais and Odean ~1998!, and Caballé and Sákovics ~1998! develop theo- retical models of financial markets where investors suffer from overconfi- dence. These overconfidence models predict that investors will trade to their detriment. 1 Our most dramatic empirical evidence supports the view that overconfi- dence leads to excessive trading ~see Figure 1!. On one hand, there is very little difference in the gross performance of households that trade frequently ~with monthly turnover in excess...

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