In his latest book, The Quest for Alpha: The Holy Grail of Investing, Larry Swedroe presents compelling research showing how difficult it is to outperform the market. In the following excerpt, he highlights two groups that try — and usually fail.
Brad M. Barber, a professor of finance at U.C. Davis, and Terrance Odean, a professor of banking and finance at the Haas School of Business at Berkeley, have done a series of groundbreaking studies on investor behavior and its impact on investment returns. Their body of work provides us with a wealth of evidence on individual investors. Their study "Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment" examined the role that gender played in investment returns. The study covered the performance of 35,000 households at a large brokerage house from February 1991 to January 1997. The following is a summary of their findings:
- Men traded 45 percent more than women.
- Turnover reduced net returns by 2.65 percent per year for men versus 1.72 per year for women.
- The turnover of single men was 67 percent greater than that of single women, presumably because of the lack of influence of a more cautious spouse.
- The increased turnover cost men 1.44 percent 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 bought them, and the stocks they sold outperformed after they were sold. Both sexes would have been better off if they had simply held the portfolios they began with.
- Those that traded the most performed the worst.
In Odean’s study “Do Investors Trade Too Much?,” he found that the average return to purchased securities was 3.3 percent less than the average return of sold securities over the next year. In his conclusion, Odean noted, “Even when trading costs are ignored, these investors actually lower their returns through trading.
Poor Returns for Investment Clubs
- The average club lagged a broad market index by 3.8 percent per year, returning 14.1 percent versus 17.9 percent.
- When performance was adjusted for exposure to the risk factors of size and value, alphas [alpha is a measure of risk-adjusted return] were negative even before transactions costs. After trading costs (turnover averaged 65 percent) the alphas were on average 4.4 percent per year.
Barber and Odean also studied the performance of investment clubs — perhaps more heads are better than one? Their study “Too Many Cooks Spoil the Profit: Investment Club Performance” covered 166 investment clubs using data from a large brokerage house from February 1991 to January 1997. Here is what they found:
The clubs would have been far better off if they had never traded during the year — beginning-of-the-year portfolios outperformed their actual holdings by 3.5 percent per year. The reason was that the stocks they sold outperformed the stocks they bought by more than 4 percent per year. The conclusion is that investment clubs have something in common with individual investors — trading is hazardous to their financial health.
Examining the results of the Mensa investment club provides an amusing bit of evidence on the ability of individual investors to produce alpha. It seems logical that if any group of individuals could beat the market, it would be the members of the Mensa club. Mensa is the largest and best-known society of people with high IQs — 98th percentile or higher. The June 2001 issue of SmartMoney reported that over the prior 15 years, the Mensa investment club returned just 2.5 percent, underperforming the S&P 500 Index by almost 13 percent per year. Warren Smith, an investor for 35 years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 would have produced almost $300,000. One investor described the strategy as “buy low, sell lower.”
Excerpted with permission of the publisher John Wiley & Sons, Inc. from The Quest for Alpha: The Holy Grail of Investing. Copyright 2011 by Larry Swedroe. This book and e-book is available at bookstores, online booksellers and from the Wiley Web site.
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