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Tuesday, 10 January 2012

The 160 Billion Dollar Bezzle

Bezzled by Their Blind Spot

It’s sort of common knowledge that private investors generally lose by over-trading; invariably individuals think this only applies to other people and not to themselves, but you're just Bamboozled by Your Bias Blind Spot. The question remains, however, just how much do private investors lose by this behaviorally challenged frenzy of trading?

Figures are hard to come by, but one rule of thumb estimate suggests that US investors gave up $160 billion dollars in 2010 through this hyperactivity. Which is a nice boost for the denizens of the underpaid and underappreciated securities industry, struggling to keep their superyachts afloat.

Uncertain Estimates

So how do we come up with this number and what does it mean? Well, there’s no easy way of doing this calculation but we can do a bit of hopeful extrapolation to come up with a number to work with. In Just How Much Do Individual Investors Lose By Trading?, Brad Barber, Yi-Tsung Lee, Yu-Jane Lui and Terrance Odean analysed the Taiwanese market and showed that individual private investor losses equated to a 3.8% penalty on their performance, equivalent to a giant 2.2% of Taiwan’s GDP each year between 1995 and 1999.

Now the paper indicates that the equivalent trading losses in the US are about half of what was seen in Taiwan, around about 2%, so to come up with a rough and ready calculation of the annualised losses of US investors we need to know the cumulative value of their stock holdings. Fortunately, the 2010 US census provides us with a number: US households hold $8,147 billion in equities and 2% of this gives us $163 billion. This is roughly 1.1% of US GDP in 2010 and equivalent to $527 per head of population; man, woman and child.


Is this credible? Well, maybe. The original paper looks at data over a decade old, the estimate of the scale of US investor losses isn’t backed up by any solid evidence I can find and it’s not a valid assumption that all US equity holders are frenzied day traders riding a one-way ticket to oblivion. It also isn't a given that you can extrapolate from Taiwan to America –research suggests Chinese and Taiwanese investors are twice as confident about their abilities to beat the market as US investors.  

On the other hand, we’ve since seen the rise of the internet and social media and ever escalating access to sources of information of variable quality which, as we shall see, serve to increase overtrading and private investor losses.  In addition, although the scale of overconfidence in Chinese markets may be higher the general trend of behavioral bias is not.  In any case, the point isn’t really whether or not this number is precise, but to come up with a rough estimate of the economic losses that private investors accrue through trend chasing. To which we can confidently say: it’s one heck of a lot.

Who Benefits?

The next question is – who benefits from this? As the paper above states:
“Our empirical analysis presents a clear portrait of who benefits from trade: Individuals lose, institutions win. While individual investors incur substantial losses, each of the four institutional groups that we analyze – corporations, dealers, foreigners, and mutual funds – gain from trade.”
Most, although not all, of individual investor losses were an effective transfer of wealth from themselves to institutions:
“Our empirical results suggest institutions profit in two ways. First, they provide liquidity to uninformed investors, thereby generating predominantly short-term profits. Second, they trade aggressively when they possess private information indicating prevailing market prices are misaligned. The profits from aggressive trading accrue over longer horizons, as the private information of institutions is gradually revealed to market participants.”
Stable Doors

In the intervening years, of course, regulators have been running around attempting to level up the playing field, but the evidence is that they can’t keep up with the hugely better funded securities industry. We’ve seen the rise of high frequency trading (see Rise of the Machines and Fall of the Machines), the introduction of dark pools (Dark Pools and Adverse Selection) and now automated analysis of social media trends (Noise, Sentiment and Stock Twits): all of which gives wealthy institutions skewed and privileged access to the data needed to make informed trading choices.  Usually this is justified on the grounds of improved liquidity, but this looks like a weak argument given the scale of the losses, even if you can figure out what it really means.

Private investors, on the other hand, have access to an increasingly varied range of babbling idiots, raising noise levels to the point where people who actually have done some proper analysis find it hard to make themselves heard. In Online Investors: Do the Slow Die First?, Barber and Odean find that after moving to online trading previously successful investors start losing:
“Those who switch to online trading perform well prior to going online, beating the market by more than 2% annually. After going online, they trade more actively, more speculatively and less profitably than before – lagging the market by more than 3% annually”.
Why, Oh Why?

So why does this happen? Why do private investors act like a bunch of baboons on a banana hunt in a warehouse full of inflatable bananas? Well, a clue can be gained from the sources of the losses:
“These losses can be broken down into four categories: trading losses (27%), commissions (32%), transaction taxes (34%), and market-timing losses (7%).”
It’s the trading and market-timing losses that equate to institutional gains, and the authors reckon that overconfidence is a major cause. The general impact of overconfidence on overtrading and consequent losses was set out in Odean and Barber’s original paper, Trading is Hazardous to Your Wealth, but is perhaps better described in Do the Slow Die First?:
“We posit that online investors become more overconfident once online for three reasons: the self-attribution bias, an illusion of knowledge, and an illusion of control”.
Behavior, Again

The self-attribution bias we’ve met before in the guise of the disposition effect – people attribute success to their own abilities and failure to factors outside of their control (see Disposed to Lose Money). The study finds that people start actively trading after they’ve had some success, which might trigger this change. The illusions of knowledge and control are behavioral findings around having access to more information – which generally doesn’t improve decision making, although we often think it does – and the additional confidence this engenders in us through the feeling that we’re in control through our powerful and purposeful mouse clicking (The Lottery of Stock Picking). Of course, we’re actually entirely at the mercy of events outside our control, which is why the mental dislocation when markets go mad can be so great, as investors struggle to handle the cognitive dissonance this creates.

Naturally, the marketing campaigns around the securities industry emphasise the need for investors to be quick, nimble and to seize every opportunity. The general problem is that the opportunities being seized are generally not ones you would want to go near in the short-term unless you’re particularly keen on handling poison ivy or wrestling an angry bear: information asymmetries in the market mean that if there is any real opportunity out there then it’s probably already been exploited by institutional investors. As Odean and Barber muse:
“Advertisments compare online trading to the old West, where the first to draw prevailed. Investors are led to believe that profitable investment opportunities are ephemeral events, seized only by the quick and vigilant. Most investors, however, benefit from a slow trading, buy-and-hold strategy. Trigger-happy traders are prone to shoot themselves in the foot”.

Of course, gunslingers of old generally preferred their targets to be unaware of their coming demise, preferably unarmed and, even more preferably, asleep. Lulling them into a false sense of security with a few shots of redeye was a darn good first step. When the bezzle is this big it’s worth investing in, but we don’t have to drink the gutrot.

In fact this isn’t really a bezzle – which is Galbraith’s term for the inventory of undiscovered embezzlement, but a febezzle, Charlie Munger’s idea of a legal form of monetary transfer in which no one thinks they’re doing anything wrong but in which their combined behavior is creating economic harm. Private investors are being legally febezzled, largely through their own efforts, and it’s high time we stopped it, even if we can't figure out exactly how much it's costing us.

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  1. There may be a parallell to this in Tetlock 2005 Expert Political Judgement, where he in some tests found that those who were well informed about foreign affairs(reading one or two quality newspapers daily) were better predictors than the experts who spent all their time collecting facts. It may be that the real time feeling one gets from being online produce more confidence than it warrants with increased trading as a result.

  2. So, when you say "we" need to stop it, who is "we"? And, how do you suggest it be stopped?

  3. These are the same kinds of studies that evaluate mutual funds and newsletters and find on average they are worthless. I really think it's a mistake to just lump traders (we're talking traders, right, not investors) into one bucket and not do case studies on why 5% are successful and 95% are screw-ups. Rather than guessing what the problem is, why not just ask? The problem with losing traders is not overconfidence; it is getting an "F" in psychology.

  4. I'm a tax preparer, mostly. From what I see, the most successful portfolios are ones which are initiated by a parent and which the child becomes attached to, or feels too guilty to sell. I have clients sitting on small fortunes of JP Morgan, Exxon, Phillip Morris, etc.

  5. The solution is easy: either passively invest in an index fund, or scrupulously follow an algorithm. Or course our preference goes to the second solution...

  6. And yet you trade stocks Timmar, and so do I. And we even write blogs telling others not to do it! ;)

    Maybe we should accept there's some other utility value in active trading that isn't captured in these studies.

    The transaction tax impact would be higher in the UK, presumably, because of stamp duty, which I believe does not apply in the US? (Presumably there's is all capital gains tax -- if you're going to trade actively as a private investor, IMHO you certainly want to be doing it in a tax-shielded way, either in an ISA or SIPP or possibly via a spreadbet).

  7. Hi Monevator

    And yet you trade stocks Timmar, and so do I. And we even write blogs telling others not to do it! ;)

    Virtually passively, though, with occasional rebalancing and dividend reinvestment. I also favour those areas where the superior institutional information gathering machinery is less likely to make a difference ...

    Maybe we should accept there's some other utility value in active trading that isn't captured in these studies.

    No question, however people also gain utility from drug use but that doesn't mean it's in their best interests, or that of society's. Even Malkeil admits that part of the attraction of stock trading is the fun of it, but getting hooked on the short term fix of a successful trade is a one-way ticket to penury.

    The transaction tax impact would be higher in the UK, presumably, because of stamp duty, which I believe does not apply in the US? (Presumably there's is all capital gains tax -- if you're going to trade actively as a private investor, IMHO you certainly want to be doing it in a tax-shielded way, either in an ISA or SIPP or possibly via a spreadbet).

    Active trading raises costs, certainly, but the main point here is that private investors trades are loss making against institutions who have preferential access to the short-term trading information needed to outperform. It's generally the case that US research translates closely to UK results, so I'd certainly think it's reasonable to read across. Tax shelters can protect us from capital gains but not from behavioural foolishness.

  8. Please we do not need any more Messiahs. The only salvation that is urgent is you been saved from your gross misconceptions about trading.

  9. >trading losses (27%), commissions (32%), transaction taxes (34%), and market-timing losses (7%).”

    I don't understand this. How are trading losses different form market-timing losses? Also, why are commissions so high? And what taxes are we speaking of? The difference between long-term and short-term capital gains? Furthermore, there are only taxes on gains, and anyone getting big gains over the last 10 years is doing quite nicely, regardless of whether they had to pay the short-term or long-term rate.

    My own impression, from reading other studies, is that almost all of of the difference in performance between individuals and institutions has to do with bad market-timing. Stupid individuals tend to buy high and sell low. Smart institutions tend to do the opposite. Bad trading (buying at market or buying on the uptick rather than buying on the downtick) is just a special case of bad market timing.

    Furthermore, most institutions are not really that smart. The true smart money is quite concentrated and is mostly individual money, but a very special class of individuals. Warren Buffett alone picks up a huge share of the total alpha available for the world stock market as a whole. Wall Street proprietary trading and hedge funds pick up most of the remaining available alpha. However, those wall street winnings are then mostly paid out to the individuals working on Wall Street or running the hedge funds, rather than to the shareholders of Wall street investment banks or the hedge fund investors.

  10. The restaurant business is similar, over 80% fail, many only last a few years as well. Trading is no different. Thus to say trading is a bad choice is incorrect. Analysis of most business situations will show a very high failure rate.

  11. Hi again Timarr,

    Shocked to hear you're now almost entirely passive, assuming you're the same Timarr who used to write very entertainingly about shares on TMF as well (or before?) here?

    If it is you then congratulations on breaking the *habit*... ;)