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«Just How Much Do Individual Investors Lose by Trading? Brad M. Barber Graduate School of Management University of California, Davis Davis, CA 95616 ...»

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Just How Much Do Individual Investors Lose by Trading?

Brad M. Barber

Graduate School of Management

University of California, Davis

Davis, CA 95616

(530) 752-0512

bmbarber@ucdavis.edu

www.gsm.ucdavis.edu/~bmbarber

Yi-Tsung Lee

Department of Accounting

National Chengchi University

Taipei, Taiwan

(886-2) 2939-3091 # 81027

actytl@nccu.edu.tw

Yu-Jane Liu

Department of Finance

National Chengchi University

Taipei, Taiwan

(886-2) 2939-3091 # 81123

finyjl@nccu.edu.tw

Terrance Odean1 Haas School of Business University of California, Berkeley Berkeley, CA 94720 (510) 642-6767 odean@haas.berkeley.edu faculty.haas.berkeley.edu/odean October 2006 We are grateful to the Taiwan Stock Exchange for providing the data used in this study.

Michael Bowers provided excellent computing support. Barber appreciates the National Science Council of Taiwan for underwriting a visit to Taipei, where Timothy Lin (Yuanta Core Pacific Securities) and Keh Hsiao Lin (Taiwan Securities) organized excellent overviews of their trading operations. We appreciate the comments of Ken French, Charles Jones, Owen Lamont, Mark Kritzberg, and seminar participants at UC-Davis, University of Illinois, the Indian School of Business, National Chengchi University, University of North Carolina, University of Texas, Yale University, the Wharton 2004 Household Finance Conference, American Finance Association 2006 Boston Meetings, and the 12th Conference on the Theory and Practice of Securities and Financial Markets (Taiwan).

Just How Much Do Individual Investors Lose by Trading?

Abstract We document that individual investor trading results in systematic and, more importantly, economically large losses. Using a complete trading history of all investors in Taiwan, we document that the aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points. Individual investor losses are equivalent to 2.2 percent of Taiwan’s GDP or 2.8 percent of total personal income – nearly as much as the total private expenditure on clothing and footwear in Taiwan. Using orders underlying trade, we document that virtually all of individual trading losses can be traced to their aggressive orders; passive orders placed by individuals are profitable at short horizons and suffer modest losses at longer horizons. In contrast, institutions enjoy an annual performance boost of 1.5 percentage points (after commissions and taxes, but before other costs). Both the aggressive and passive trades of institutions are profitable.

Financial advisors recommend that individual investors refrain from frequent trading.

Investors should buy and hold diversified portfolios, such as low cost mutual funds. If skill contributes to investment returns, individual investors are obviously at a disadvantage when trading against professionals. What is less clear is just how much do individual investors lose by trading?

In this paper, we document that trading in financial markets leads to economically large losses for individual investors and virtually all of the losses of individual investors can be traced to their aggressive (rather than passive) orders. To do so, we use a unique and remarkably complete dataset, which contains the entire transaction data, underlying order data, and the identity of each trader in the Taiwan stock market – the World’s twelfth largest financial market. With these data, we provide a comprehensive accounting of the gains and losses from trade during the period 1995 to 1999.

Our data allow us to identify trades made by individuals and by institutions, which fall into one of four categories (corporations, dealers, foreigners, or mutual funds). To analyze who gains and loses from trade, we construct portfolios that mimic the purchases and sales of each investor group. If stocks bought by an investor group reliably outperform those that they sell, the group benefits from trade. In addition, using the orders underlying each trade, we are able to examine whether gains and losses can be attributed to aggressive or passive orders.

Our empirical analysis presents a clear portrait of who benefits from trade: Individuals lose, institutions win. While individual investors incur substantial losses, each of the four institutional groups that we analyze – corporations, dealers, foreigners, and mutual funds – gain from trade. Though we analyze horizons up to one year following a trade, our empirical analyses indicate that most of the losses by individuals (and gains by institutions) accrue within a few weeks of trade and reach an asymptote at a horizon of six months.

Several prior studies provide evidence that individual investors lose from trade, 1 while institutions profit. 2 Relative to prior research, the combination of a comprehensive dataset (all For studies of the performance of individual investors, see Schlarbaum, Lewellen, and Lease (1978a, 1978b), Odean (1999), Barber and Odean (2000, 2001), Grinblatt and Keloharju (2000), Goetzmann and Kumar (2005), and Linnainmaa (2003a, 2003b). Recent research suggests some trades by individual investors are systematically profitable. Ivkovich and Weisbenner (2004) document the local holdings of individual investors perform well, while Ivkovich, Sialm, and Weisbenner (2004) document individuals with concentrated portfolios perform well. Coval, Hirshleifer and Shumway (2003) provide evidence that some individual investors are systematically better than others. Other related work includes Lee, Shleifer, and Thaler (1991), Sias and Starks (1997), Bartov, Radhakrishnan, and Krinsky (2000), Chakravarty (2001), and Poteshman and Serbin (2003).





trades for an entire market) and the empirical methods we employ provide far more convincing evidence that individuals lose from trade.

The comprehensiveness of our dataset allows us to go beyond the mere documentation of trading losses and make two important contributions relative to prior research. First, we document the losses incurred by individual investors are economically large. We estimate the total losses to individual investors to be $NT 935 billion ($US 32 billion) during our sample period or $NT 187 billion annually ($US 6.4 billion).3 This is equivalent to a staggering 2.2 percent of Taiwan’s gross domestic product or roughly 33, 85, and 170 percent of total private expenditures on transportation/communication, clothing/footwear, and fuel/power (respectively). Put differently, it is a 3.8 percentage point annual reduction in the return on the aggregate portfolio of individual investors. These losses can be broken down into four categories: trading losses (27 percent), commissions (32 percent), transaction taxes (34 percent), and market-timing losses (7 percent).

The trading and market timing losses of individual investors represent gains for institutional investors. The institutional gains are eroded, but not eliminated by the commissions and transaction taxes that they pay. We estimate that aggregate portfolio of institutional investors enjoys annual abnormal returns of 1.5 percentage points after commissions and transaction taxes (but before any fees the institutions might charge their retail customers). When profits are tracked over six months, foreigners earn nearly half of all institutional profits; at shorter horizons, foreigners earn one fourth of all institutional profits. The profits of foreigners represent an unambiguous wealth transfer from Taiwanese individual investors to foreigners. Whether the remaining institutional profits represent a wealth transfer depends on who benefits when domestic institutions profit.

A distinguishing feature of our dataset is data on the orders underlying each trade. This feature of our dataset leads to the second main contribution of our study: Virtually all of the losses For studies of mutual fund performance, see Carhart (1997), Chan, Jegadeesh, and Wermers (2000), Coval and Moskowitz (2001), Daniel, Grinblatt, Titman, and Wermers (1997), Grinblatt and Titman (1989, 1993), and Wermers (2000). For studies of pension fund performance, see Ferson and Khang (2002), Lakonishok, Shleifer, and Vishny (1992), Coggin, Fabozzi, and Rahman (1993), Christopherson, Ferson, and Glassman (1998), Delguercio and Tkac (2002), Coggin and Trzcinka (2000), Ikenberry, Shockley, and Womack (1998).

In analyses of, Ackermann, McEnally, and Ravenscraft (1999), Brown, Goetzmann, and Ibbotson (1999), Liang (1999), and Agrawal and Naik (2000) provide evidence of superior returns, though Amin and Kat (2003) argue that hedge fund performance results may be attributable to the skewed nature of hedge fund payoffs, which when appropriately accounted for, renders hedge fund performance unremarkable.

The average exchange rate that prevailed during our sample period was $NT 29.6 per $US 1.

incurred by individuals can be traced to their aggressive orders.4 In contrast, institutions profit from both their passive and aggressive trades.5 At short horizons (up to one month), the majority of institutional gains can be traced to passive trades. The profits associated with passive trades are realized quickly, as institutions provide liquidity to aggressive, but apparently uninformed, investors. The profits associated with the aggressive trades of institutions, which are likely motivated by an informational advantage, are realized over longer horizons.

The remainder of the paper is organized as follows. Our data, the Taiwan market, and empirical methods are described in detail in Section I. We present our main results in Section II, where we estimate the magnitude of losses and trace these losses to aggressive and passive orders underlying trade. In Section III, we discuss the economic significance of the gains and losses. We make concluding remarks in Section IV.

I. Background, Data, and Methods I.A. Taiwan Market Rules The TSE operates in a consolidated limit order book environment where only limit orders are accepted. During the regular trading session, from 9:00 a.m. to noon during our sample period, buy and sell orders interact to determine the executed price subject to applicable automatching rules. 6 During our sample period, trades can be matched one to two times every 90 seconds throughout the trading day. Orders are executed in strict price and time priority. Although market orders are not permitted, traders can submit an aggressive price-limit order to obtain matching priority. During our study period, there is a daily price limit of seven percent in each direction and a trade-by-trade intraday price limit of two ticks from the previous trade price.

The TSE caps commissions at 0.1425 percent of the value of a trade. Some brokers offer lower commissions for larger traders, though we are unable to document the prevalence of these price concessions. Taiwan also imposes a transaction tax on stock sales of 0.3 percent. Capital All orders on the Taiwan Stock Exchange are limit orders. We define aggressive limit orders to be buy limit orders with high prices and sell limit orders with low prices (both relative to unfilled orders at the last market clearing); we define passive limit orders to be buy limit orders with low prices and sell limit orders with high prices. Sixty-four percent of all trades emanate from aggressive orders.

5 Parlour (1998), Foucault (1999) and Handa, Schwartz and Tiwari (2003) explore the choice between demanding liquidity with market or marketable limit orders and supplying liquidity with limit orders that cannot be immediately executed. Griffiths et al. (2000) find that aggressive buys are more likely than sells to be motivated by information.

Trading also occurred on Saturdays during most of our sample period. Before December 1997, Saturday trading occurred from 9:00-11:00. From January to March, 1998, stocks were traded only on the second and the fourth Saturday in each month. From April 1998 to December 2000, Saturday trading occurred from 9 am to noon. From 2001 on, there has been no trading on Saturday.

gains (both realized and unrealized) are not taxed, while cash dividends are taxed at ordinary income tax rates for domestic investors and at 20 percent for foreign investors. Corporate income is taxed at a maximum rate of 25 percent, while personal income is taxed at a maximum rate of 40 percent.

I.B. Trades Data and Descriptive Statistics We have acquired the complete transaction history of all traders on the TSE from January 1, 1995, through December 31, 1999. The trade data include the date and time of the transaction, a stock identifier, order type (buy or sell), transaction price, number of shares, and the identity of the trader. The trader code allows us to broadly categorize traders as individuals, corporations, dealers, foreign investors, and mutual funds. The majority of investors (by value and number) are individual investors. Corporations include Taiwan corporations and government-owned firms (e.g., in December 2000 the government-owned Post, Banking, and Insurance Services held over $NT 213 billion in Taiwanese stock). Dealers include Taiwanese financial institutions such as Fubon Securities, Pacific Securities, and Grand Cathay Securities. Foreign investors are primarily foreign banks, insurance companies, securities firms, and mutual funds. During our sample period, the largest foreign investors are Fidelity Investments, Scudder Kemper, and Schroder Investment Management. Mutual funds are domestic mutual funds, the largest being ABNAMRO Asset Management with $NT 82 billion invested in Taiwanese stocks in December 2000.

We present basic descriptive statistics on the market during the 1995 to 1999 period in Table 1. In contrast to the U.S., which enjoyed an unprecedented bull market in the late 1990s, Taiwan experienced average annual return of 6.9%. The main index for the Taiwan market (the TAIEX – a value-weighted index of all listed securities) enjoyed gains of over thirty percent in 1996 and 1999 and losses of over twenty percent in 1995 and 1998. Our sample period also includes the period of the Asian Financial crisis, which began in May 1997 with a massive sell-off of the Thai Bhat.



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