In this week's Big Saturday Interview we're fortunate to have with us Terrance Odean, Assistant Professor of Finance at the Haas School of Business at the University of California, Berkeley. He taught finance at U.C. Davis from 1997 through 2001. For over a decade, Terrance has studied different aspects of the behavior of active traders and investors and published his findings in numerous academic papers. His research has appeared in The Wall Street Journal, The New York Times, The Los Angeles Times, The Washington Post, The International Herald Tribune, Time, Newsweek, U.S. News and World Report, Barron's, Forbes, Business Week, Smart Money, Bloomberg Personal, Worth, Kipplinger's Personal Finance, and other publications. While studying for his Ph.D., Odean worked at Wells Fargo Nikko Investment Advisors and IRIS Financial Engineering and co-owned a seat on the Pacific Stock Exchange. Terrance has a B.A. in Statistics at the University of California, Berkeley in 1990 and a Ph.D. in Finance from the Haas School of Business at the University of California, Berkeley in 1997.

"...I was certainly one of the first people to look at the trading database from the point of trying to understand the psychology of investors and what makes them do the kinds of things they do..."

Eddie: Terrance, thank you for taking time out of your schedule today. I'm looking forward to an interesting conversation.

Terrance: Thank you for inviting me on today.

Eddie: Okay let's get started. Would you please tell us about your background and what got you initially interested in the financial markets? I understand that prior to your academic career you actually were an active trader in stocks, is that correct?

Terrance: Sure. It's true, I traded just as an individual investor during the late 80s and I did a lot of things that, these days, I wouldn't do and I don't advise that others in general do either. I traded pretty actively and I traded somewhat speculatively.

Occasionally I made money, but I probably lost money more often than I would have liked.

I got interested in finance from an academic perspective in sort of a roundabout way. I had thought that I'd get my Ph.D. in psychology and I had taken some classes from Daniel Kahneman, who's a psychologist who was teaching at Berkeley at the time. He had done research on "behavior decision theory" which deals with how people make decisions. And I went to his house one day to talk about graduate school and to ask him whether I could study with him for my Ph.D. He suggested that I consider going into finance.

"...I wasn't keeping a very good track of whether I was coming out ahead or losing money. I think a lot of investors do that...."

Eddie: Did he know something of your trading activities at the time?

Terrance: He knew that I had had a non-academic interest in the financial markets. He pointed out that there might be very good research opportunities in trying to apply cognitive psychology to finance and that while it was somewhat risky, it would pay-off well academically.

Eddie: Over the past 25 years I've been involved in the financial markets, I've never heard of anyone who does the type of formal academic research on the behavior of traders and investors that you do. Would you say that you're pretty much a maverick in this field?

Terrance: I think there are more people doing it these days. In fact, I've made research data that I was able to obtain available to other researchers in this field. In the last few years, other people have obtained other datasets in the U.S. and other countries. But I was certainly one of the first people to look at the trading database from the point of trying to understand the psychology of investors and what makes them do the kinds of things they do. In the last few years there has definitely been a lot more interest in this area.

Eddie: That would make sense, given that the population of active investors has exploded over the past decade, in spite of the bear market. Terrance, even before you developed an academic interest and you began to dabble in trading, did you have a friend or family member you'd credit with planting the seed in your head?

"...people hold on to their losers and tend to sell their winners.
Well, every time they sell a winner, they tend to feel pretty good about it...."

Terrance: Yeah, I had a friend who was trading pretty actively and he introduced me to his broker and this broker was happy to have a client who liked to trade a lot.

Eddie: And once you got started trading, what kind of strategy did you use?

Terrance: It was not a very systematic approach and actually that's one of the things that got me interested in getting more education. I went back to school and got my undergraduate degree in statistics. And while I was taking some psychology classes and getting a Ph.D. in psychology, I was studying statistics. I remember when I was doing some trading on my own, realizing that I wasn't taking a very methodical approach to all of this. I realized that it would be good to take look at it from a statistical point of view. I suspect that, at times, I wasn't keeping a very good track of whether I was coming out ahead or losing money. I think a lot of investors do that. I would look back and say, "Oh, I made money on that one!" or "I lost money on that one." But I really didn't sit down and figure out, which was bigger? Did that one loss wipe out a couple of gains?

Eddie: Yes, it's always possible for a trader to have a string of small winning trades. Each of those ones gives the trader a certain amount of pleasure and confidence in his trading skills. But then the trade might have a large loss which wipes out most of the cumulative gain from the winning trades. But then I would guess that the losses don't hurt so much because of the good feelings stirred up by all those winning trades.

Terrance: Yup. I think a lot about what investors do and what I observe them doing when I look at their their trading records is to they try to manage the emotions around investing. So, for example, people hold on to their losers and tend to sell their winners. Well, every time they sell a winner, they tend to feel pretty good about it. They say, "Well I bought it and then sold it at a higher price." Now by holding on to their losers, they postpone judgment on that investment and they say, "Well...it's a paper loss! It can still come back!" And they just postpone the regret that way. And occasionally it will come back and sometimes they'll take a whopping loss. But they're not making decisions that make a lot of sense from an investment perspective. But they are making decisions that make them feel better emotionally about their investing.

"...Institutional investors do a lot better than individual investors...
They probably have rules that they follow...as a group, they probably follow a methodical approach to investing
...much more so than individuals as a group.

Eddie: I know you have did a formal study on this particular subject. One of your findings was that overconfidence makes people hold on to losing trades while selling winning trades too early. That's something that people in the world of trading of have known for a long time, but you actually put numbers to it.

Terrance: Yes, I found that people have a tendency to do that. They they hold on to to losers and sell winners. I find this to be the case with individual investors who had accounts at discount brokers in the U.S. But subsequently, I also studied -- along with a couple of couple of colleagues...Brad Barber up at UC Davis and a couple colleagues in Taiwan -- the investors in Taiwan. We found the same tendency for all the investor groups.

Eddie: You've stated that this has its origins in broad tendencies in human psychology and I would guess that it is the same thing as people putting off hard decisions. But they pay a price for doing that, right? And then that in turn causes more pain in the future when they have to face reality.

Terrance: Oh sure, of course. And the research that prompted me to look at this initially came from the Kahneman and Tversky work on prospect theory. They were psychologists. They were not looking at decision making in the context of investments. They were looking at it in a number of different settings. The decision-making process is similar for investing and a lot areas.

Eddie: What we do at TradingMarkets is teach people how to trade systematically according to a set of well-defined rules. We tell people to follow them with great discipline, don't second-guess and keep the emotions out of it. Have you done any research on the trading performance of people who are able to trade systematically as opposed to the individuals you've studied who probably use discretionary judgment to make their trading decisions?

Terrance: I have not done research on that explicitly. What I have researched is the relative success of individual investors vs. institutional investors. Institution investors do a lot better than individual investors. And I would say that there's probably underlying reasons for that. One would be that institutional investors do have access to better information. But the other reason would be closer to what you are suggesting. The institutional investors are more likely to have a systematic approach to investing. They probably have rules that they follow. I'm not saying this true of every institution, but I am saying that, as a group, they probably follow a methodical approach to investing...much more so than individuals as a group.

Eddie: And there could be individuals who trade systematically.

"...We found that there are daytraders who figure it out. Absolutely true... people who had been making money in the previous six months,
we could forecast that they would be, as a group, successful going forward. "

Terrance: Yes, obviously there could be individuals who are methodical and institutions who are quite emotional. But I think institutions are more likely to have rules that they pay attention to and in my research they are more successful, at least in the samples that we've looked at.

Eddie: Obviously, individuals have to deal more with their emotions because they're trading their own money. I mean, people are very attached to their life savings in their bank account.

Terrance: In the case of the institutional investor, he's trading someone else's life savings (laughs).

Eddie: And you know what, there's a great irony to that. You tend to mismanage that with which you have the closest relationship with.

Terrance: I realize you're trying to help people improve their trading, but it's important to realize that investors who are investing their life's savings do have the option of not actively trading. They can buy and hold a well-diversified low-cost mutual fund, such as an index fund. For the majority of people with most of their money in 401K plans, retirement funds and savings plans...this is the way to go. You are far better off holding an index fund and taking the market return--and being charged low fees--than you are being as a casual, emotional and not particularly well-informed investor.

Eddie: I totally agree with you. We advocate that anybody who wants trade needs to receive a proper education. It's no different from someone who wants to be a surgeon. You have the make the time, discipline yourself, learn from their right people and find a systematic approach that you're able to trade correctly and not second-guess. If you make these commitments, they should let someone else manage their money.

"Let's hold on to the index fund...who brought the coffee cake?"

Terrance: And if you look at a lot of institutional investors these days, even the ones who are doing active management are often holding the bulk of their equity in an index fund and then they do active investing around that.

Eddie: Actually, you are pretty much summing up what we consider to be a prudent money management approach for an individual active trader or investor to take. We teach people to put the majority of their capital into a conservative investment and trade only a small percentage, like 1% or 2% of their capital. I would guess that the vast majority of investors you've studied do not do that. By trading in small pieces like that, you not only lower your risk, but you also decrease the degree of emotional attachment to every trade that you put on.

Terrance: You're giving a lot of diversification there. I think that's important because if I look at my studies of tens of thousands of investors, the average investors do not do as well as the buy-and-hold investors. Obviously, they'll be exceptions. That said...there are a number of reasons to manage your own account. Number one is the control the tax implications. The other reason is that you derive some enjoyment from it. You may enjoy studying the markets.. You may feel that you have a sense of control over things. I think it's fine to gratify those desires. But you have to be careful to not take excessive risks in the process.

Eddie: I absolutely agree. One of the most intriguing studies that you did...I think this was one of the more recent ones that you did in Taiwan...you found that there was a small concentrated group of daytraders who were able to make money consistently year after year. These were the ones whose past performance tended to be a good indicator of how well they would perform in the future.

Terrance: Yup. We found that there are daytraders who figure it out. Absolutely true. But we found that the vast majority, don't. So what people have been saying about daytrading for a long time essentially remains true. Namely, it is inherently risky and you lose money. It's not impossible, though, because some people are able to figure out how to get ahead doing this.

Eddie: Have you done any studies yet on the characteristics of traders who are able to consistently make money?

"...And we ran the analysis and found that men traded 45% more actively than women..."

Terrance: No, the only thing that we know is that people who had been making money in the previous six months...we could forecast that they would be, as a group, successful going forward.

Eddie: Another interesting study revealed the consistently poor performance of investor clubs. I mean the whole intent behind these groups is to pool peoples' knowledge in order to formulate better decisions. What were your findings?

Terrance: We looked at investment clubs and found that they not only underperformed a buy-and-hold approach, they also underperformed individual investors. The reasons for that is that investment clubs trade quite actively and they do that because, well that's the function of many clubs. People get together each month and they talk about what to buy and what to sell.

The investment club that has the approach of buying an index fund for 10 years is not an exciting place. They'd basically get together each month and say, "Okay what do we do?" And the answer is always, "Let's hold on to the index fund...who brought the coffee cake?" So you know, what the clubs are about is finding stocks and buying and selling them. So they tend to trade a bit actively.

And we also have another paper where we speculate that part of their underperformance comes from the group decision process. People tend to suggest stocks that are difficult to refute. So people will suggest companies that have been doing very well. I'm not saying this is always true, but investment clubs tend to buy stocks that are simply well-admired. And these are the companies that are probably overvalued because too many people are admiring them. So that's another reason why they don't do well. But the main thing we wanted to point out by our study was that investment clubs are not the secret to being successful.

Eddie: Another area of study you've done is gender, and you found out that there was a consistent difference between the performance of male investors versus female investors.

Terrance: I had written a theoretical paper that more overconfident investors would trade more and, as a result, would earn less. And Brad Barber and I were looking at this and we wanted to test it. And we had done some reading in the psychology literature that said that men, on average, tend to be more overconfident than women. This was particularly the case in the mathematical sciences, finance...things like that.

And so we thought, well let's see if men are trading more actively than women and what's that doing to their returns. So we had data on about 30,000 investors were we knew the gender of the person who had opened the account. And we knew whether the person was married or not. And we ran the analysis and found that men traded 45% more actively than women in our sample. Both men and women tended to underperform a buy-and-hold approach. But men underperformed by about 1% more than women.

Eddie: Interesting.

Terrance: So they were churning their accounts.

Eddie: Terrance, suppose that you have a son or daughter and 20 years from now he/she says: "Dad, I'm happy with my chosen career and I'm going continue with it. But I have a burning desire to learn how to become a short-term trader. Don't worry, I won't do it full time. But I'm doing well with my job and I want to see if I can earn a better return than from a mutual fund."

What advice would you give him/her to have the best shot at being successful?

Terrance: My advice would be that he rigorously back-test his strategies on out-of-sample data. Furthermore, he should be careful to account for commissions and market liquidity.

Eddie: Well, that's certainly a good start. Terrance, I know you're going to be speaking to a group in Taiwan and that you have to get ready for the trip. So I just want to thank you for joining us today.

Terrance: Thank you for having me on.

Editor's note: I welcome your questions and comments about my conversation with Terrance Odean. I'd love to hear your feedback. Also feel free to let me know of anyone you'd like to see interviewed in the Big Saturday Interview. Email me at eddiek@tradingmarkets.com. Have a great weekend!

Eddie Kwong
Editor-in-Chief
TradingMarkets.com