Lesson 9.4 · 4 of 5 · Beginner psychology
Trading too often: what it costs and what Barber and Odean found
Frequent trading is expensive: commission, spread and currency conversion on every order, plus tax on gains paid sooner. In Barber and Odean’s study, the households that traded most earned 11.4% a year, against 17.9% for the market. A single decision day each month keeps you out of the trap.
Terms in this lesson
- Trading commission
- What it costs you to buy, sell and hold shares at a broker.
- Bid-ask spread
- The gap between the price you can sell at and the price you can buy at, at the same moment.
- Day trading
- You buy and sell on the same day, to profit from small price moves.
- Index fund
- A fund that buys every company in an index, in the same proportions.
Opening question
Two investors are equally good at picking shares. One trades once a month, the other ten times a week. Who probably has more after five years?
If the picks are equally good, costs make the difference. Every trade pays commission and spread, and dozens of trades a month add up to large sums. That is exactly what Barber and Odean measured.
It does not matter if you get it wrong: trying first helps you remember.
What frequent trading costs
Even a small trading commission is multiplied by the number of trades.
You buy slightly above and sell slightly below the quoted price: the spread.
Every sale at a profit can bring a tax bill now, instead of letting gains grow for years. In the UK an ISA avoids this, but not the other costs.
Work it out
You make 4 trades a month, each of $1,000. Commission, spread and currency conversion together cost you 0.5% of each trade. How many dollars do you pay in a year?
A hint
Multiply the trades per year by the amount and by 0.5%.
4 × 12 × $1,000 × 0.005 = $240 a year. On a $4,000 portfolio, that is 6% a year gone before you have earned anything.
The Barber and Odean study on frequent trading
Real case
What did Barber and Odean find?
Those who traded most earned least.
Brad Barber and Terrance Odean studied the accounts of 66,465 households at a US discount broker from 1991 to 1996. The average household turned over 75% of its portfolio each year, and the most active more than 250%. The paper, published in 2000, has a title that says it all: “Trading Is Hazardous to Your Wealth”.
Annual returns after costs, 1991 to 1996: the market 17.9%, the average household 16.4%, the most active households 11.4%.
Check yourself
Why did the households that traded most fall behind?
How sure are you?
Before costs, the authors found very little difference between the groups. Costs made the difference: at the time, a round-trip trade of over $1,000 cost on average 3% in commission and 1% in spread.
Work it out
The most active households earned 11.4% a year and the market 17.9%. By how many percentage points did they fall behind each year?
This exercise is in the free account, where we also save your progress.
Create a free accountThe one-decision-a-month rule
Ready to start?
How does the rule work?
You make decisions about your portfolio once a month, on a fixed day.
On that day you add your monthly amount, check whether your mix has drifted a long way and, if you have a written reason, buy or sell. For the rest of the month you press no buttons. Read and learn as much as you like: the rule applies to the button, not to your curiosity.
Myth or fact?
“The more often I watch the market and the faster I react, the more I earn.”
This exercise is in the free account, where we also save your progress.
Create a free accountWhat would you do?
It is the middle of the month. A share in your portfolio has dropped 8% on a news story. Your decision day is the 1st. What do you do?
This exercise is in the free account, where we also save your progress.
Create a free accountWhat you learned
- Every trade costs commission and spread, and sometimes currency conversion and tax.
- In Barber and Odean’s study, the most active traders earned 11.4% a year, 6.5 points below the market.
- A single decision day each month cuts costs and decisions made in the heat of the moment.
One more time
The questions you got wrong, asked a different way.
Check yourself
What did Barber and Odean find when they compared results before costs?
Before costs, frequent traders did not do very differently. After costs, they trailed the market by 6.5 percentage points a year.
You reached the end
Keep what you learned
With a free account we remember your lessons, bring back the questions you got wrong exactly when you need them and keep your streak.
Save your progress with a free accountLessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: Brad M. Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, The Journal of Finance, vol. 55, no. 2 (2000). The calculations assume constant returns.