Question

Barber and Odean, in their 2002 Journal of Finance paper entitled “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” state that:

“Our most dramatic empirical evidence supports the view that overconfidence leads to excessive trading. On one hand, there is very little difference in the gross performance of households that trade frequently (with monthly turnover in excess of 8.8 percent) and those that trade infrequently. In contrast, households that trade frequently earn a net annualized geometric mean return of 11.4 percent, and those that trade infrequently earn 18.5 percent.” Attempt to explain these findings using the behavioural finance theory.

Answer 1

Similar to the underlying argument is a paper by the same authors- Barber, Odean(2002) "Online Investors: Do the Slow Die First".

In the paper "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors", the argument is very much similar to the one mentioned above i.e., Overconfidence leads to excessive trading, which can further result in high trading levels and the resulting poor performance of individual investors.

It was analyzed that households significantly underperform, after a reasonable accounting for transaction costs.

It is the cost of trading and the frequency of trading, not portfolio selections, that explain the poor investment performance of households during the sample period.

Behavioral Finance literature (Barber, Odean 2002) tells that overconfident investors trade more actively, more speculatively, and less profitably than before, which lowers their average utilities since overconfident investors trade too aggressively when they receive information about the value of a security. It is difficult to reconcile these findings with rational behavior.