In 1984, Amos and I and our friend Richard Thaler visited a Wall Street firm. Our host,
a senior investment manager, had invited us to discuss the role of judgment biases in
investing. I knew so little about finance that I did not even know what to ask him, but I
remember one exchange. “When you sell a stock,” I asked, “who buys it?” He answered with a
wave in the vague direction of the window, indicating that he expected the buyer to be
someone else very much like him. That was odd: What made one person buy and the other
sell? What did the sellers think they knew that the buyers did not?
Since then, my questions about the stock market have hardened into a larger puzzle: a
major industry appears to be built largely on an illusion of skill. Billions of
shares are traded every day, with many people buying each stock and others selling it to
them. It is not unusual for more than 100 million shares of a single stock to change hands
in one day. Most of the buyers and sellers know that they have the same information; they
exchange the stocks primarily because they have different opinions. The buyers think the
price is too low and likely to rise, while the sellers think the price is high and likely
to drop. The puzzle is why buyers and sellers alike think that the current price is wrong.
What makes them believe they know more about what the price should be than the market
does? For most of them, that belief is an illusion.
In its broad outlines, the standard theory of how the stock market works is accepted by
all the participants in the industry. Everybody in the investment business has read Burton
Malkiel’s wonderful book A Random Walk Down Wall Street. Malkiel’s central idea is
that a stock’s price incorporates all the available knowledge about the value of the
company and the best predictions about the future of the stock. If some people believe
that the price of a stock will be higher tomorrow, they will buy more of it today. This,
in turn, will cause its price to rise. If all assets in a market are correctly priced, no
one can expect either to gain or to lose by trading. Perfect prices leave no scope for
cleverness, but they also protect fools from their own folly. We now know, however, that
the theory is not quite right. Many individual investors lose consistently by trading, an
achievement that a dartthrowing chimp could not match. The first demonstration of this
startling conclusion was collected by Terry Odean, a finance professor at UC Berkeley who
was once my student.
Odean began by studying the trading records of 10,000 brokerage accounts of individual
investors spanning a seven- year period. He was able to analyze every transaction the
investors executed through that firm, nearly 163,000 trades. This rich set of data allowed
Odean to identify all instances in which an investor sold some of his holdings in one
stock and soon afterward bought another stock. By these actions the investor revealed that
he (most of the investors were men) had a definite idea about the future of the two
stocks: he expected the stock that he chose to buy to do better than the stock he chose to
sell.
To determine whether those ideas were well founded, Odean compared the returns of the
stock the investor had sold and the stock he had bought in its place, over the course of
one year after the transaction. The results were unequivocally bad. On average, the shares
that individual traders sold did better than those they bought, by a very substantial
margin: 3.2 percentage points per year, above and beyond the significant costs of
executing the two trades.
It is important to remember that this is a statement about averages: some individuals
did much better, others did much worse. However, it is clear that for the large majority
of individual investors, taking a shower and doing nothing would have been a better policy
than implementing the ideas that came to their minds. Later research by Odean and his
colleague Brad Barber supported this conclusion. In a paper titled “Trading Is Hazardous
to Your Wealth,” they showed that, on average, the most active traders had the poorest
results, while the investors who traded the least earned the highest returns. In another
paper, titled “Boys Will Be Boys,” they showed that men acted on their useless ideas
significantly more oft en than women, and that as a result women achieved better
investment results than men.