Trading is hazardous to your wealth

The catchy title of this post is an homage to the seminal study of Barber & Odean (2000) who examine the investment performance of individual investors (per July 2020 the study has been cited almost 3,800 times). The authors investigate a data set consisting of more than 66,000 households (during the period of 1991 to 1996). To keep things short, I will only refer to the insights of the study.

First, individual investors have an annual turnover of roughly 75%, which means that most assets investors hold at the beginning of a given year are, at the end of the year, replaced by other assets.

The following figure presents gross and net returns of quintile portfolios based on monthly turnover (February 1991 to January 1997). While the annualized mean of individual investors’ gross returns (18.7%, white bar) slightly exceeds that of the S&P 500 (17.9%), net returns are well below (16.4%, black bar).

Returns of portfolios based on monthly turnover (Source: Barber & Odean (2000), p. 775, Figure 1)

Histograms on the left-hand side clearly point out the impact of high portfolio turnover. While trading has little impact on gross returns, net returns strictly decrease in turnover. More precisely, annual returns reduce from 18.5% (Low Turnover) to less than 11.5% (High Turnover). In other words: Net returns decline by almost 38%. Altough trading costs are lower for other portfolios, annual net returns of Portfolio 4 still reduce to about 15%.

Does this mean you should have zero turnover? In brief: No.

Barber & Odean conducted their study 20 years ago. Nowadays, trading costs are less pronounced and inexpensive trading vehicles like ETFs (see my post on ETFs) make it possible to invest in almost every market worldwide. Furthermore, you should continue to conduct meaningful trades. However, you should avoid unnecessary trades or ‘impulse purchases’.


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Author: Admin
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