Behavioral Finance And Indexing

June 12, 2008



Terrance Odean, Willis H. Booth Professor of Banking and Finance, University of California at Berkeley

JoI: What does behavioral finance tell us about investing and indexing?

Terrance Odean, University of California at Berkeley (Odean): Due to a number of behavioral biases, many investors make systematic mistakes when buying and selling stocks. On average, the stocks they sell go on to outperform those they buy. When it comes to mutual funds, most investors focus on past performance and pay too little attention to expenses and other fees. Many investors would be far better off buying broad-based index funds or other low-cost, well-diversified mutual funds.

JoI: What are the biggest mistakes investors make from a behavioral standpoint?

Odean: The most costly mistake made by a large number of investors is under-diversification. Many investors trade too actively. Investors also pay too little attention to trading costs and mutual fund fees. They focus too much on the one thing that they can't control—market outcomes—and too little on important factors over which they do have some control—diversification, costs and taxes.

JoI: Is behavioral finance being used to justify poor investment decisions and a lack of education?

Odean: I'm not sure I understand the question. The advice I give investors is to buy low-cost, well-diversified mutual funds such as index funds. I believe that that is excellent real-life advice. I occasionally suggest, tongue in cheek, that investors do the opposite of their instincts (i.e., buy the stocks they are inclined to sell and vice versa). Of course, this would be an idiotic way to extrapolate from my own research to real life.

JoI: If indexing is proven to provide the best odds for long-term success, why don't more investors index?

Odean: I don't know if indexing provides the best odds for long-term success. I do know that it is a very good choice for most investors. People don't choose indexing for a variety of reasons. Some people are overconfident in their ability to beat the market; others are unaware of the advantages—or perhaps even the option—of indexing.

JoI: Can active managers use behavioral insights to outperform the market?

Odean: Yes. Individual investor behavior can affect asset prices. Active managers who have insights into that behavior and asset price dynamics could potentially profit from those insights. I doubt that many active managers currently do profit from such insights. Even if some active managers are earning profits from such insights, they may not be passing those profits on to their clients. For example, my co-authors and I found that from 1995 through 1999, institutional investors in Taiwan earned an annual alpha of approximately 1.5 percentage points after trading costs. If, on average, they charged their clients less than 1.5 percentage points in fees, then those clients are benefiting. However, if the fees averaged over 1.5 percentage points, the managers reaped all of the benefits.

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