Essay Behavior of Individual Investors

3412 Words Jan 2nd, 2016 14 Pages
The Behavior of Individual Investors*
Brad M. Barbera and Terrance Odeanb aGraduate bHaas

School of Management, University of California, Davis, Davis, CA 95616, USA. Tel.:+1 (530) 752 0512
School of Business, University of California, Berkeley, Berkeley, CA 94720, USA. Tel.:+1 (510) 642 6767

Contents
1. The Performance of Individual Investors 1.1 The Average Individual

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1.1.1 Long-Horizon Results 1.1.2 Short-Horizon Results 1.1.3 Market vs. Limit Orders

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1.2 Cross-Sectional Variation in Performance
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2. Why do Individual Investors Underperform?
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2.1 Asymmetric Information
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2.2 Overconfidence
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2.3 Sensation Seeking
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2.4
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Barber and Terrance Odean

assumptions yield powerful insights into how markets work. For example, in the Capital
Asset-Pricing Model—the reigning workhorse of asset-pricing models—investors hold well-diversified portfolios consisting of the market portfolio and risk-free investments.
In Grossman and Stiglitz’s (1980) rational expectations model, some investors choose to acquire costly information and others choose to invest passively. Informed, active, investors earn higher pre-cost returns, but, in equilibrium, all investors have the same expected utility. And in Kyle (1985), an informed insider profits at the expense of noise traders who buy and sell randomly.
A large body of empirical research indicates that real individual investors behave differently from investors in these models. Many individual investors hold under-diversified portfolios. Many apparently uninformed investors trade actively, speculatively, and to their detriment. And, as a group, individual investors make systematic, not random, buying and selling decisions.
Transaction costs are an unambiguous drag on the returns earned by individual investors. More surprisingly, many studies document that individual investors earn poor returns even before costs. Put another way, many individual investors seem to have a desire to trade actively coupled with perverse security selection ability!
Unlike those in models, real investors tend to sell winning investments while holding on to

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