Innovator Article

The Irrational Individual Investor

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In the crowded field of behavioral economics and finance, Professor Brad Barber has carved out a niche as one of the world’s leading experts on individual investor performance, stock buying and selling behavior, and portfolio diversification. Over the past dozen years, Barber and co-author Terrance Odean, professor of finance at UC Berkeley’s Haas School of Business, have shown unequivocally that “trading can be hazardous to your wealth.”

Their latest working paper, “The Behavior of Individual Investors,” sifts through 37 years of research. “The investors who inhabit the real world and those who populate academic models are distant cousins,” Barber and Odean note. “In theory, investors hold well diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice, investors behave differently.”

Barber and Odean say that individual investors who ignore advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment.

Larry Swedroe, a principal and research director for The Buckingham Family of Financial Services, highlighted the study on CBS MarketWatch, saying: “This raises such questions as: ‘Why do so many investors self-manage portfolios when they could earn better returns with lower risk in low-cost mutual funds, such as index funds? And why do investors with portfolios of individual equities actively trade when doing so lowers their expected returns?’”

“The bottom line is that investors who don’t know they perform poorly end up believing that they’re doing well—the incompetent are unaware.”

- Larry Swedroe
   Buckingham Family of Financial Service

Alternative Investments Fuel Endowments

After years of double-digit returns, the steep losses incurred by elite university endowments in 2009 caused schools like Princeton and Harvard, which relied heavily on endowment funding for ongoing operational expenses, to slash spending. Many began to question the investment model endowments like theirs tend to follow.

Barber partnered with Guojun Wang, a UC Davis economics Ph.D. candidate, to analyze university endowment returns using data from 1991 to 2010. Their working paper, “Do (Some) University Endowments Earn Alpha?,” shows that consistent alpha returns for elite university endowments over the last 20 years—alpha meaning the returns higher than that of a standard benchmark index—come from not stocks and bonds but from private equity and hedge funds.

The top five university endowments—Harvard, Yale, Stanford, Princeton and The University of Texas—collectively manage almost a fourth of the $350 billion managed by all university endowments combined. Barber and Wang found that the returns earned by these endowments are driven by large allocation to alternative asset classes (e.g., private equity and hedge funds). For institutions with smaller endowment funds, alternative asset classes play a relatively small role in explaining returns. The strong returns earned by elite institutions can be entirely explained by their allocation to alternative asset classes.

“Clearly, the public stock and bond benchmarks do not represent alpha-generating asset classes,” Barber and Wang conclude. “However, one might argue the alternative investment strategies themselves represent alpha.”


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