Terrance Odean on why investors are their own worst enemies – Common investor behaviour

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By Petra Löwer On Aug 27, 2022

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Terrance Odean on why investors are their own worst enemies – Common investor behaviour | The Economic Times

27 Aug 2022, 11:52 AM IST

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Common investor behaviour

Eminent finance professor Terrance Odean says individual investors are their own worst enemies. as they are overconfident, shortsighted and are anything but rational. Odean has spent his career studying investors who are overconfident, shortsighted and far more likely to buy a stock at the worst possible moment than to make the kind of contrarian bet that pays off in the long run.”Many of the mistakes investors make come from a lack of any understanding of the innate disadvantages they face,” Odean said in a lecture to finance professionals.

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Who is Terrance Odean?

Terrance Odean is a finance professor at the University of California who teaches at the Haas School of Business. His research on how psychologically motivated decisions affect investor welfare and securities prices has been cited in numerous publications including The Wall Street Journal and The New York Times.

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Investors’ greatest sins

Odean from his years of research around the world came up with investors’ greatest sins which are:Overconfidence- Odean says humans seem to be hardwired to expect success and to regard themselves as above average which is mostly not the case.Excessive Trading- Odean believes commissions, taxes and poor timing of buy and sell decisions suck billions out of the pockets of individual investors so hence they should avoid over tradingGoing with the crowd- Odean says investors are often attracted to stocks because others want them. In fact, individuals are much more likely to buy and sell the 10% of stocks mentioned in the news and ignore the other 90%Stubbornness- According to Odean few investors are willing to admit defeat and hence are more likely to sell winners and trigger capital gains taxes than to sell their losers and avoid them.

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What can investors do?

As a result of these sins committed by investors, Odean said the stocks held by retail investors typically underperform the ones they sell. He shared five tips for reversing this trend:1.Invest for the long run2. Buy and hold3. Diversify4. Keep your investment costs and fees down5. Pay attention to taxes.Odean wrote some investment lessons from his years of research which can help investors avoid big mistakes while making investment decisions.

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Excessive trading is hazardous to your wealth

Odean says from his years of research it has been found that investors who traded least actively outperformed the traders who traded most actively by an average of 5.5 per cent points a year.He believes that many active traders are overconfident in their ability to pick stocks.

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Odean says investors are far more likely to sell their winners than their losers.”While, in general, investors should avoid active trading, if they need to sell stock to raise cash they should sell their losers – at least in a taxable account. In this way, they get a tax write off now and postpone realizing capital gains. If the loss is sufficient, they should consider selling simply to capture the tax benefit,” he says.

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Pay attention to do the things you can do

Odean says many investors concentrate on picking winning stocks but it is mostly found that they aren’t able to do so.”I’ve found that, on average, the stocks investors sell subsequently outperform the stocks they buy – even before subtracting transaction costs. Most investors would be better off forgetting about picking winners and paying attention to doing the things they can actually do. Controlling trading costs, managing taxes, and diversifying,” he says.

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Remain calm under pressure

Odean says investors shouldn’t make long- term investment decisions in panic and should evaluate their portfolio when they are calm. “Decide whether your mix of stocks, bonds , and other assets is appropriate for your goals and emotional and financial ability to sustain losses. If you need help figuring this out, get it. This is a much more fundamental decision than which stocks to pick. If a market downturn churns your stomach, go for a walk. When the market, and your stomach, have settled, re-evaluate the risk profile of your portfolio,” he says.

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Odean says mutual funds are the optimal investment for most investors hence investors should buy funds with no-loads, low expense ratios, and low turnover .”Index funds are a good choice for many people,” he says.

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Only keep 10% risky stocks in your portfolio

Odean says if investors really enjoy trading stocks they should consider putting 90% of their stock portfolio into mutual funds and treating the remaining 10% as an ‘entertainment’ account.
“If you keep the entertainment account small enough that you can comfortably sustain some losses, you can go ride the rollercoaster of risky stocks to your heart’s content,” he says.

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Don’t check your portfolio on a daily basis

Odean says investors should avoid following their portfolio returns day to day as if they do, short-term market losses may chase them out of the market.”If you have an appropriate, well-diversified portfolio, it doesn’t need constant tune-ups,” he says.

(Disclaimer: This article is based on Terrance Odean‘s various interviews and speeches “)

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