Behavioural Finance
Trading Too Much
Why frequent trading tends to reduce returns, what a famous study of brokerage accounts found, and how overconfidence fuels the habit.
Many investors believe that watching markets closely and trading often will earn higher returns. Evidence suggests the opposite.
The famous study
In 2000, economists Brad Barber and Terrance Odean published a study titled Trading Is Hazardous to Your Wealth. They analysed tens of thousands of household accounts at a US discount broker from 1991 to 1996.
- The average household earned returns roughly in line with the market before costs.
- But the most active traders, those who turned over their portfolios most often, earned far lower returns: around 11 percent a year, compared with about 18 percent for the market.
Trading costs and poorly timed trades ate away their returns.
Why people overtrade
- Overconfidence: people believe they can pick winners and time the market.
- Illusion of control: acting feels better than waiting.
- Entertainment: trading can feel exciting, like a game.
- Information overload: constant news creates the urge to react.
Barber and Odean also found men traded more than women and earned lower returns as a result, which they linked to overconfidence.
The costs of trading
- Brokerage and fees, even if small per trade.
- Taxes on short-term gains, which are often higher than long-term rates.
- Bid-ask spreads.
- Bad timing: buying after rises and selling after falls.
Zero-commission trading
Many apps now offer free trades, but trading still has costs through spreads, taxes and poor timing. Free trading can even encourage more trading.
A better approach
- Invest for the long term with a clear plan.
- Limit how often you check your portfolio.
- Use systematic investment plans that invest automatically.
Two neighbours invest the same amount. One buys an index fund and checks it once a year. The other trades several times a week based on tips and news. After ten years, the patient investor has more money, largely because the active trader paid more in costs and often bought high and sold low.
Frequent trading usually adds costs and mistakes. Patience is often more profitable.
- A study found the most active traders earned about 11 percent a year versus 18 percent for the market.
- Overconfidence, excitement and news drive overtrading.
- Fees, taxes, spreads and bad timing reduce returns.
- Long-term, systematic investing avoids these costs.
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