Bad timing

 By Guest Blogger Doug Rowat

Brad Barber and Terrance Odean. Know of them? Perhaps not, but you should.

Mr. Barber and Mr. Odean were researchers at the University of California who conducted a landmark study of investor behaviour during the 1990s. They looked at the trading activity of roughly 78,000 households at a large US discount brokerage over a six-year period. What they discovered was revealing.

Households that traded their stock portfolios the most had, by far, the worst performance. The highest turnover portfolios had an average annualized return of 11.4%, but the lowest turnover portfolios had a significantly better return of 18.5%. (If these returns seem impressive, it’s because it was the bull-market years of the 1990s.) The annualized blended-benchmark return (buy and hold) was roughly 18%. A conservative stock portfolio might have annual turnover of 20%—the highest turnover portfolios in the Barber and Odean study were realizing this every MONTH.

So what were these frequent traders doing wrong? The mistakes were numerous. Certainly overestimating their ability to determine market direction, an enormously complex task, was a key factor in their underperformance. Overconfidence led them astray, essentially. But there were other errors. They also traded emotionally. For instance, they held stocks that had recently underperformed the market and sold their winners, which was “consistent with the evidence that individual investors tend to hold their losers and sell their winning investments”. Our experience with our own clients is similar. When a client wants to raise money from their portfolio, often they suggest selling only the positions that have performed well, ignoring the fact that positive fundamentals are likely the reason for the strong performance and that it could easily continue. Repeatedly selling your winners usually only serves to blunt momentum.

Another amazing revelation of the Barber and Odean study was how poorly diversified most of these stock portfolios were. The mean household in their study held only 4.3 stocks! Recall the blog post I wrote a few months ago (http://www.greaterfool.ca/?s=hail+marys) highlighting that the odds of any one stock suffering a catastrophic loss (a 70% drop) is about 40%. If you have only a four-stock portfolio, you’re living dangerously.

Much of what Barber and Odean concluded has been supported by other analysis. For instance, Blackrock notes that you only need to miss a handful of strong market days to absolutely cripple your long-term portfolio performance (see chart). Over thousands of trading days do you believe that you’ll be able to accurately determine the few strongest market days and, by corollary, the few weakest days? Get over yourself.

Investment of $100,000 in S&P 500 (1995-2014): Market Timing is Pointless.

Source: Blackrock

Interestingly, Barber and Odean also determined that men trade 45% more often than women. And, lo and behold, underperformed women in terms of net returns. Sadly gentlemen, overconfidence once again gets the better of us. As Barber and Odean describe it

Overconfident investors believe more strongly in their own valuations, and concern themselves less about the beliefs of others. Overconfident investors…hold unrealistic beliefs about how high their returns will be and how precisely these can be estimated.

Put another way, even though your buddies have advised you that you’re an ugly slob, you still decide to ask Scarlett Johansson out on a date. You can, of course, do this, but just be aware that she’ll tell you to get lost every time (or call the police).

I don’t highlight the Barber and Odean study to suggest that portfolios should never be traded. They should. It makes sense, for instance, to periodically rebalance your portfolio and also to subtly shift asset and geographic weightings in response to broad changes in economic conditions or interest-rate outlook. But having 200% portfolio turnover because you view yourself to be a human algorithm? This is a poor strategy.

Dial it back, flash boys.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.