Fear and Greed Drive the Stock Market

Terrance OdeanUniversity of California, Berkeley

SKAGEN Funds New Years’s Conference 2011

• What do we know about investor behavior?

• Why does it matter?

– Market prices

– Investor welfare

Investor Biases• Confusion about probability → Underdiversify.• Overconfidence → Trade too much.• Desire to reduce regret → Cling to losers.• Limited attention → Buy attention grabbing

stocks.• Confusion about probability → Chase

performance.

Underdiversification

• Bill Gates vs.• Enron employees

– 62% of Enron employee 401(k) investments were in company stock

Investor Biases• Confusion about probability → Underdiversify.• Overconfidence → Trade too much.• Desire to reduce regret → Cling to losers.• Limited attention → Buy attention grabbing stocks.• Confusion about probability → Chase performance.

When All Traders Are Above Average(i.e., overconfident) Odean, 1998, Journal of Finance

• Trade more.

• Earn less.

• Underdiversify.

• Increase market volatility.

Do Investors Trade Too Much?Odean, 1999, American Economic Review

Excluding Non-Speculative Trades Odean, 1999, American Economic Review

Monthly Turnover and Annual Performance of Individual Investors

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5

10

15

20

25

1 (LowTurnover)

2 3 4 5 (HighTurnover)P

erce

nt A

nnua

l R

etur

n M

onth

ly T

urno

ver

Net Return Turnover

Trading is Hazardous to Your WealthBarber and Odean, 2000, Journal of Finance

"Overall, men claim more ability than do women, but this difference emerges most strongly on … masculine task[s].”

Deaux and Ferris (1977)

0

20

40

60

80

100

All Women All Men SingleWomen

Single Men

Boys will be BoysBarber and Odean, 2001, Quarterly Journal of Economics,

-3

-2

-1

0

AllWomen

All Men SingleWomen

SingleMen

“Own Benchmark” Annual Net Returns Barber and Odean, 2001, Quarterly Journal of Economics

online

Data = Expertise

Learning to be Overconfident(Gervais & Odean, 2001, Review of Financial Studies)

• Self-attribution bias. People take too much credit for their own successes.

Illusion of Control

• Who rolls the dice.

Investor Biases• Confusion about probability → Underdiversify.• Overconfidence → Trade too much.• Desire to reduce regret → Cling to losers.• Limited attention → Buy attention grabbing stocks.• Confusion about probability → Chase performance.

Panel A: Discount Households

0.0

1.0

2.0

jan feb mar april may june july aug sep oct nov dec

PGR

/PLR

Taxable TDAs

Rate at which Gains are Realized Relative to Losses

Source: Barber and Odean, 2003, Journal of Public Economics

Disposition Effect in TaiwanBarber, Lee, Liu, Odean, 2007, European Financial Management

0

1

2

3

4

5

6

7

8

<-4

2

-36

-28

-20

-12 -4

4 12

20

28

36

44

52

60

Lik

elih

oo

d o

f r

ep

urch

as r

ela

tive t

o s

tocks s

old

fo

r lo

ss w

ith

zero

su

bseq

uen

t retu

rn

Percent return since sale

Relative Rate at which Investors Repurchase Stocks Previously Sold

Originally Sold for Gain

Orignially Sold for Loss

19Source: Barber, Odean, & Strahilevitz, 2010.

Investor Biases• Confusion about probability → Underdiversify.• Overconfidence → Trade too much.• Desire to reduce regret → Cling to losers.• Limited attention → Buy attention grabbing

stocks.• Confusion about probability → Chase performance.

All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual

and Institutional InvestorsBarber and Odean, Review of Financial Studies, 2008

• Thousands of stocks.• Bounded rationality and processing ability.• Limit search to stocks that catch attention.• Investors buy stocks that catch their attention.

Simulation Volume Sort

-40

-30

-20

-10

0

10

20

30

1 2 3 4 5 6 7 8 9 10a 10b

Partitions Sorted on Same Period Trading Volume

Pe

rce

nt

Ord

er

Imb

ala

nc

e

-40

0

40

1 2 3 4 5 6 7 8 9 10a 10b

Partitions of Stocks Sorted on Current Day's Abnormal Trading Volume

Perc

ent O

rder

Imba

lanc

e .

Large Discount Brokerage

Large Retail Brokerage

Small Discount Brokerage

Abnormal Volume Sort IndividualsImbalance by # trades

Source: Barber & Odean 2008.

Order Imbalance: Volume Sorts

TAQ & ISSM Data: 1983-2000

-20.00

-10.00

0.00

10.00

20.00

Lowest

Abnormal

Volume

Highest

Abnormal

Volume

Abnormal Trading Volume

Bu

y / S

ell

Imb

ala

nc

e

Individual Investors (Number of Trades)

Individual Investors (Value of Trades)

Simulation Return Sort

-15

-10

-5

0

5

10

15

20

1a 1b 2 3 4 5 6 7 8 9 10a 10b

Partitions Sorted on Previous Period's Return

Pe

rc

en

t O

rd

er Im

ba

lan

ce

25

-5

0

5

10

15

20

25

30

1a 1b 2 3 4 5 6 7 8 9 10a 10b

Partitions of Stocks Sorted on Previous Day's Return

Perc

ent O

rder

Imba

lanc

e Large DiscountBrokerage

Small DiscountBrokerage

Large Retail Brokerage

Return Sort IndividualsImbalance by # trades

Source: Barber & Odean 2008.

Order Imbalance: Return Sorts

TAQ & ISSM Data: 1983-2000

-4.00

0.00

4.00

8.00

12.00

Lowest

Day

Previous

Return

Highest

Day

Previous

Return

Previous Day's Return

Individual (Number of Trades)

Individual (Value of Trades)

27

Investor Biases• Confusion about probability → Underdiversify.• Overconfidence → Trade too much.• Desire to reduce regret → Cling to losers.• Limited attention → Buy attention grabbing stocks.• Confusion about probability → Chase

performance.

2 3 3 4 6 7 9 1015

39

05

1015202530354045

10 (W

orst) 9 8 7 6 5 4 3 2

1 (Best

)

Performance Decile

Perc

enta

ge o

f Buy

sMutual Funds: Money Pours into

Last Year’s Winners

Source: Barber, Odean, and Zheng

• What do we know about investor behavior?

• Why does it matter?

– Market prices

– Investor welfare

Do Retail Trades Move Markets? Barber, Odean, & Zhu, Review of Financial Studies 2009

• Purchases and sales of individual investors are highly correlated

• Higher percentage of individual investor buy orders this week → more buy orders next week → higher returns next week → lower returns next month

• Higher percentage of individual investor buy orders this year → lower returns next year → in the subsequent year high idiosyncratic risk stocks bought by

individuals underperform those sold by 13 percentage points.

Monthly Percentage Four-Factor Abnormal Returns for Value-Weighted Portfolios formed on the basis of Weekly Proportion Buyer-Initiated Trades using

Small and Large Trades: February 1983 to December 2000

Barber, Odean, Zhu, 2009, Review of Financial Studies

Monthly Four-Factor Alpha

(%) t-statistic

Panel A: Contemporaneous Returns Proportion

Buyer-Initiated Quintile

Small Trades

Large Trades

Small Trades

Large Trades

1 (Sold) -2.398 -7.398 -9.79 -38.96 2 -1.205 -5.718 -6.57 -29.36 3 -0.422 -1.091 -3.37 -11.73 4 0.413 4.111 4.20 31.91

5 (Bought) 1.786 8.062 10.92 35.87

B-S (5-1) 4.184 15.460 11.99 39.37

Panel B: Subsequent Returns Proportion

Buyer-Initiated Quintile

Small Trades

Large Trades

Small Trades

Large Trades

1 (Sold) -0.637 0.421 -5.16 3.57 2 -0.160 0.797 -1.87 8.06 3 0.161 0.276 1.70 3.53 4 0.427 -0.219 4.81 -2.79

5 (Bought) 0.733 -0.362 5.22 -3.96

B-S (5-1) 1.370 -0.782 6.55 -5.54

Monthly Percentage Abnormal Returns for High Idiosyncratic Risk Stocks for Value-Weighted Portfolios formed on the basis of Annual Proportion Buyer-Initiated Trades

using Small Trades: 1984 to 2001

Barber, Odean, Zhu, 2009, Review of Financial Studies

Just How Much Do Investors Lose from Trade?

Mean Daily ProfitsInstitutions

Millions $NTIndividuals

Million $NTGross Trading Profits

178.0 (178.0)

Gross Market-timing Profits

46.4 (46.4)

Commissions (25.6) (216.9)

Transaction Tax (27.0) (228.4)

Net Profits 171.8 (669.7)

Source: Barber, Lee, Liu, and Odean, Review of Financial Studies, 2009

Economic Significance• Net Annual Individual Trading Losses are 2.2% of GDP.

• Individual Trading Losses Represent a 3.8% reduction in annual portfolio performance.

• Institutional Gains Represent a 1.5% increase in annual portfolio performance.

• 46.2 % of individuals’ gross daily losses are to foreign investors.– $3.5 million US per day

Source: Barber, Lee, Liu, and Odean, Review of Financial Studies, 2009

U.S. vs. Taiwan

• Taiwanese investors trade more actively.

• U.S. investors face more asymmetric information risk.

Do institutional investors have biases?

• Disposition effect • Extrapolating recent past?• Self-attribution bias• Overconfidence

– models– risk and leverage