Aggressive Trading Likely Leads to Large Losses
The Review of Financial Studies, 2009

As more and more people invest to save for college educations and their retirements, research shows that aggressive trading in these accounts can lead to large losses. Professor Brad Barber has published “Just How Much Do Individual Investors Lose by Trading?” in The Review of Financial Studies in collaboration with Y-Tsung Lee of National Chengchi University, Y-Jane Liu of the Guanghua School, Peking University and National Chenggchi University, and Terrance Odean of the Haas School of Business at the University of California, Berkeley.

Using a complete trading history from 1995 to 1999 of all investors in Taiwan’s stock market, the world’s 12th largest, Barber et al. examined the gains and losses from trades made by individuals and by institutions, which fall into one of four categories: corporations, dealers, foreigners or mutual funds. They found that, on average, individuals lose, while institutional investors gain from trading.

The authors show that trading 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. The authors estimate 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 (seven percent). Meanwhile, 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. Barber et al. estimate the 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. They warn that this level of loss by individual investors is significant and potentially expensive for nation states.

Rather than trying to time the market or actively trading individual stocks, Barber and his co-authors strongly recommend that individuals invest in well-diversified, low-cost index funds that are designed to deliver the market rate of return.

Barber is the first recipient of the Maurice J. and Marcia G. Gallagher Endowed Chair of Finance. His selection was based on his years of exceptional teaching, insightful and influential research, and service to the academic and business communities.