Throughout much of my youth — back when Bork was still a proper noun rather than an impertinent verb — received economic wisdom rested on the bulwark of the rational, welfare-maximizing actor. Human beings, so the dogma dictated, are rational actors who consume and convert information in order to maximize wealth, minimize risk, and optimize their well-being. Coase was in his element, and all was right with the world.
Real human beings don't behave this way. The roster of affirmatively perverse behaviors is now so deep that economics must treat the neoclassicism of the late twentieth century as this discipline's equivalent of Ptolemaic astronomy: a once-dominant paradigm whose systematic dismantling will provide work for an entire generation of scientific newcomers.
Within my range of vision, the latest item to confirm the preeminence of empirically validated behavioral economics over its more theoretical neoclassical counterpart is a review essay by Brad M. Barber and Terrance Odean, The Behavior of Individual Investors (featured in a New York Times business column). To wit:
We provide an overview of research on the stock trading behavior of individual investors. This research documents that individual investors (1) underperform standard benchmarks (e.g., a low cost index fund), (2) sell winning investments while holding losing investments (the “disposition effect”), (3) are heavily influenced by limited attention and past return performance in their purchase decisions, (4) engage in naïve reinforcement learning by repeating past behaviors that coincided with pleasure while avoiding past behaviors that generated pain, and (5) tend to hold undiversified stock portfolios. These behaviors deleteriously affect the financial well being of individual investors.
The details of this essay, and of the more thorough literature that it surveys, are nothing short of shocking. Consider Barber and Odean's conclusions about the inverse relationship between turnover and alpha:
[Among] households [sorted] into quintiles based on their monthly turnover from 1991-1996. . . . [t]he 20 % of investors who trade most actively earn an annual return net of trading costs of 11.4%. Buy-and-hold investors (i.e., the 20% who trade least actively) earn 18.5% net of costs. The spread in returns is an economically large 7 percentage points per year.
These raw return results are confirmed with typical asset-pricing tests. Consider results based on the Fama-French three-factor model. After costs, the stock portfolio of the average individual investors earns a three-factor alpha of -31.1 basis points (bps) per month (-3.7 percentage points (pps) annually). Individuals who trade more perform even worse. The quintile of investors who trade most actively averages annual turnover of 258%; these active investors churn their portfolios more than twice per year! They earn monthly three-factor alphas of -86.4 bps (-10.4 pps annually) after costs.
Note the persistence of a seven-percent spread between the households with the most and the least turnover. That seven-percent spread, it nearly goes without saying, is dangerously close to the entire historic average annual return on equity investments in publicly traded United States capital markets.
Given this forum's recent exploration of prospect theory, I hasten to add this: Barber and Odean's discussion of the disposition effect among retail investors figures prominently among the high points of this review essay. Retail investors systematically sell winners too soon and cling to losers too long. This behavior not only erodes returns; it is horribly tax-inefficient in the sense that it generates taxable capital gains (often at less favorable rates governing short-term gains) and eliminates deductible capital losses. This "bad disposition" is a variation on the broader theme of prospect theory. We hate to lose. Because we hate losing, that is precisely what we do.
When we aggregate all of the self-destructive behaviors of real investors (in sharp contrast with the predictions of formal models based on capital asset pricing, rational expectations, and the like), we must conclude that retail investors really would trade all their tomorrows for one single yesterday. To think that American society has conducted a multigenerational experiment in transferring market risk from employers, government, and other institutional fiduciaries to the very employees and retirees who comprise this class of retail investors. Ah, freedom. At this rate, behavioral finance will prove as a practical matter — even if this branch of the social sciences imposes no discipline whatsoever on actual behavior — that freedom really is just another word for nothing left to lose: