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From the June 19, 2005 Break Out Report

Home Made Butter:
How people decrease their returns by churning their accounts
by Marco den Ouden

"The investor's chief problem, and even his worst enemy, is likely to be himself."

- Benjamin Graham

Unscrupulous brokers are sometimes charged with betraying their clients with a practice known as churning. Simply put, it is when a broker who is given discretionary management of an account trades his client in and out of stocks excessively. The trades generate handsome commissions for the broker, but they often leave the portfolio flat. Either the trades made are poor or much of the profit (if there is any) is eaten up by commissions.

Churning is generally considered to be an action that is abusive to the client, and sometimes it is actionable and results in law suits and even criminal charges.

But studies have shown that the advent of online trading and the popularity of day trading has led to what might be called home-made churning. Terrance Odean and Brad Barber, two professors in the Graduate School of Management at the University of California at Davis published a study in 1999 showing that investors generally trade too much to the detriment of their portfolios and the ease of trading online has only exacerbated the problem.

In Do Investors Trade Too Much? they analyzed trading records for 10,000 accounts at a large discount brokerage, almost 100,000 transactions altogether. They discovered that, on average, stocks purchased underperformed stocks sold to finance those purchases. In other words, the investor would have been better off holding on to his stock rather than trading into a different one.

Looking further into the nature of this excessive trading, they discovered that investors tend to sell their winners and hold onto their losers. They use the proceeds of these sales to buy into the tail-end of a momentum stock then hang on for the ride down. (It's happened to me, so I know what they're talking about.)

Even when eliminating trades that might be motivated by liquidity demands, tax loss selling, risk reduction or portfolio rebalancing, the results remain. Trading lowers returns.

Odean and Barber also note that men tend to trade more often than women in their study Boys Will be Boys, and as a result, women outperform men with their portfolios. Men trade 45% more than women and earn annual risk-adjusted net returns that are 1.4% less annually. The difference is even more pronounced comparing single men and single women. Single men trade 67% more and earn 2.3% less than single women. The difference, they note, is not that women are better stock pickers but that they trade less often.

In Trading is Hazardous to Your Wealth they studied the activities of over 65,000 households with accounts at a major brokerage between 1991 and 1996.    They discovered that those who traded the most had an average annual return of 11.4% against an average return for all households of 16.4%. The market returned 17.9%. The average household turns over 75% of its common stock portfolio annually.

The families, on average, actually did do better than the market return of 17.9% before transaction costs are considered - 18.7%. But the transaction costs, brokerage fees and bid-ask spreads, ate into those returns reducing them to 16.4%.

Critics of the Barber-Odean studies have argued that, because the period of the studies was between 1991 and 1996, it doesn't take into account today's razor-thin online commissions. But clearly, commissions can't account for the fact that the return for the most active investors was only 11.4%.

In 2002, another of their studies, Online Investors: Do the Slow Die First?, looked at 1607 investors who switched from phone-based to online trading. They found that those who switched usually outperformed the market by 2% before switching, but "after going online, they trade more actively, more speculatively, and less profitably than before - lagging the market by more than three percent annually". They attribute this again to overconfidence - "the illusion of knowledge, and the illusion of control".

Terrance Odean Addressing a Las Vegas Investorís Conference, 2003

These guys are university profs, so their studies are long documents of 40 - 60 pages each. Their prose is generally readable, but sometimes abstruse, especially when they get into mathematical formulae. You can find these articles as readable short synopses and in their entirety at Terrance Odeanís page at the University of California .

The lesson here, of course, is be careful and don't get cocky. Investing is not easy. And it's not a game or a sport, though some people treat it as if it is. You want to whip that cream into a frothy, sweet and tasty treat - a profitable portfolio. Churn it too much and you'll get butter!


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