Online overconfidence

October 13, 1999|By Gail MarksJarvis

SAVING money by trading stocks online may be costing you a fortune.

It appears that something happens to investors when they put a mouse in their hand. They seem to get trigger-happy. And it hurts.

A study by Brad Barber and Terrance Odean at the University of California-Davis confirms it. When investors go online, they change. They start to speculate on stocks rather than invest for the longer term. Their new behavior doesn't work as well as the more steady approach they took before going online.

Messrs. Odean and Barber analyzed 1,607 investors who switched from making trades by telephone to trading online. When this group of investors incurred the time and expense of calling brokers, it beat the market by more than 2 percent a year. But when the investors went online, they underperformed the market by more than 3 percentage points.

The researchers attribute the decline to the investors' more aggressive, frequent trading. And the cause: overconfidence.

The Odean-Barber team has been researching investor overconfidence for a couple of years. It's one of investors' worst enemies.

When they compared male and female investors in a previous study, women were the clear winners. Neither group was any better at picking stocks. Both tended to sell stocks at the wrong time and buy stocks at the wrong time.

But men fared worse because their overconfidence led them to buy and sell more frequently. The trading costs and commissions for buying and selling stocks ate away at their returns.

In the latest study, the researchers analyzed brokerage statements for 1,607 investors who each had at least a six-year track record and switched to online trading. That group was compared with another 1,607 investors who had been investing as long but didn't switch.

The group that moved to the Internet had a far superior performance before going online than the group that stuck with old-style broker contact.

The study's authors think the outstanding performance -- probably stemming from luck rather than ability -- is what led the group to feel overly confident and move online. Once on the Internet, the researchers think, the investors had access to so much information they felt even more confident. That led to aggressive and frequent trading.

Compelled to trade

The researchers also think the investors felt compelled to trade stocks simply because they had invested time in research. Psychological studies have shown that people don't want to waste their time taking in information if they don't use it. Messrs. Odean and Barber think investors feel the urge to trade because they've done research on the Web.

Speculative turnover (or short-term buying and selling) nearly doubled when investors went online. And after switching online, the investors' average annual turnover rate increased from 73.7 percent to 95.5 percent. The researchers think investors using traditional brokers may also want to buy or sell stocks more actively.

The investors who switched to online trading sacrificed returns because the stocks they sold did better than the ones they bought, and the trading and commission costs added up because they were trading more. Investors tend to ignore these costs when calculating returns -- and shouldn't.

The study authors don't want investors to give up online trading. They simply suggest investors keep their finger off the trigger so they get the advantage of the lower online rates.

Gail MarksJarvis writes for the Saint Paul (Minn.) Pioneer Press.

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