Overconfidence is your biggest enemy

If you consider yourself to be a better-than-average share investor, you’re not alone according to new US research.

A recently-published study by Brad Barber and Terrance Odean from the University of California found that overconfidence seems to play a key role in explaining why retail investors underperform when they switch from phone-based to online trading. This is the opposite to what one might expect given that 'straight-through' order processing is widely promoted as a positive development which leads to faster, more profitable trading results.

To examine the reasons for this deterioration in performance, they analysed the trading behaviour of 1,607 share investors who switched from phone-based to online trading during the 1990s. The results make fascinating reading.

Prior to going online, investors in the sample typically recorded strong trading performances. On average, they beat their self-nominated market index by a net 2.4% annually (i.e. after trading costs). Once online, however, their performance fell away dramatically. Net of trading costs, they under-performed their own benchmark by 3.5% per annum.

Other changes in trading behaviour were also noted. After going online, investors tended to trade more actively and more speculatively than before. In most cases their portfolios were tilted toward small growth stocks with a high level of market risk. On this score, there were striking differences between the sexes with men trading almost one and a half times more frequently than women and recording lower net returns.

The authors believe that the deterioration in investment performance, and associated rise in trading activity, was mainly because online investors tend to become overconfident. Three cognitive biases - self attribution bias, the illusion of knowledge and the illusion of control - appear to play a key role.