FOOL'S EYE VIEW
Is Trading Online Good For You?

By Stuart Watson (TMFTiger)
December 22, 2000

Great Titchfield Street, London -- It's generally accepted that trading online has many advantages over normal phone-based dealing services. It's quicker, more convenient and most of all a lot cheaper. But what effect does it have on the performance of your investments?

Cold hard facts

A piece of research examining this very question was published last year by two academics from the University of California, Davis, called Brad Barber and Terrance Odean. They examined the performance of 1,600 investors who "moved online" between 1991 and 1996. They found that the group outperformed the market by 2% a year before going online but underperformed by 3% a year afterwards. That's an enormous swing. As we say in the Ten Steps: small differences in returns matter, a lot.

Barber and Odean found that investors traded more frequently once going online but the quality of their decisions actually got worse. So they suffered the double whammy effect of poorer gross returns compounded by higher overall charges, despite the average charge per trade coming down. Although commission comes down remember that other charges like stamp duty and the bid-offer spread do not.

Before going online the average turnover of each investor was 70%. This shot up to 120% immediately after they went online before falling back to 90% after a couple of years. Turnover was measured by adding all the sales and purchases made in a period, halving this total and then expressing it as a percentage of the total portfolio value.

They also found that the amount of speculative trading doubled after going online. Speculative trading was defined as trading that was not for the purposes of raising cash, tax planning or rebalancing of the portfolio. Interestingly enough, the type of companies that people invested in did not appear to change, but the frequency with which they nipped in and out did.

They concluded that the overtrading after going online resulted from overconfidence and an illusion of both knowledge and control. They finished off by saying "trigger-happy investors are prone to shooting themselves in the foot". Let's take each point in turn.

Overconfidence

It is believed that most people are overconfident about their own abilities. For example, most people think they are above-average drivers, which of course cannot actually be true. This overconfidence encourages us to trade more. The fact that the investors outperformed beforehand may have encouraged them to trade more simply because they thought they were good at it.

Illusion of Knowledge

Does having more knowledge mean you make a better decision? Not necessarily. It depends on the quality of that knowledge and how well we interpret it. Are we being presented with biased knowledge meaning that we can't make a balanced assessment of the potential risks and rewards? The simple fact that there is vastly more information available to online investors can breed even more overconfidence.

Illusion of Control

Have we outperformed the market due to the quality of your decisions or have we simply got lucky? There is a concept called self-attribution bias that simply means that we tend to attribute our successes to our own actions rather than simple chance. The extreme market conditions of recent years mean this point is even more relevant now. If we are beating the market, to paraphrase Clint Eastwood, we should constantly ask ourselves: are we just being lucky?

What lessons should we learn from this?

I don't think this research is nearly so gloomy as it first appears. But it does reinforce some important points. I think trading online is preferable because, all else being equal, your overall returns will increase due to the lower costs. So make sure all else really is equal by not letting online trading affect your overall strategy.

When it comes to share dealing it appears that the law of diminishing returns applies. The more decisions you make the lower their quality is likely to be. This makes sense, because you will have less time to make each decision and you are more likely to have to make compromises about your investing criteria.

Finally, we should always be questioning matters. Is this information I am basing my decision on both reasonable and wide-ranging enough? Am I beating the market only because I got lucky with my timing? It's definitely food for thought when you are munching on your turkey or chewing a mince pie.

How much do you turn over your portfolio each year? Cast your vote here.

Where Next?
Get A Broker – but don't overtrade!
Full research paper
Investment Psychology discussion board