Mistake #1: disregarding transaction costs
Individuals tend to buy and sell without regard to transaction costs. Profitable traders realize that one would buy a stock only if one's profit objective exceeds transaction costs. Generally, transaction costs are composed of commissions, which vary depending on your choice of brokerage firm, and the bid-ask spread, which ranges from a quarter to half a tick per share.
In Odean's study, the average cost for buying and selling a stock position was 5.9 percent. Unfortunately, the average trader was not willing to hold a stock until it appreciated that much, preferring to sell it as soon as its price registered a smaller gain. As a result, the accounts that traded the most were the least profitable.
Odean also found that women were consistently more profitable than men. It seems that the predilection of males to be trigger-happy also applies to the world of investing, as they consistently trader trade more often than their feminine counterparts. The higher commission bills generated by these extra transactions handicap men's accounts, allowing women to earn more profits.
Mistake #2: Buying momentum stock too late
Retail traders often like momentum stocks, but wait too long to buy them. Odean found that investors are indeed attracted to momentum stocks. However, they tend to wait until these stocks have run for a number of years before they are willing to initiate a position. By this time, the price of the stock is so far away from the fair value of the company that they sharply underperform the market at the fist sign of trouble. According to Odean, it is likely that these investors are often the last ones to buy these stocks and among the first to suffer losses when the trend reverses to the downside.
Momentum investing is a viable strategy in the stock market. Many studies have documented momentum patterns in stock returns. However, these stocks establish reliable trends for only 12 months or so, and afterward tend to reverse.
The bottom line: If you are going to trade momentum stocks, remember that trends don't last forever!
Mistake #3: Selling winning positions
Traders may sell winning positions but hold losing positions. The transactions studied by Odean clearly showed that the average retail investor is quick at taking profits, and is especially fond of selling those stocks that have appreciated significantly in the two weeks following purchase. However, if a purchased stock goes down, the typical investor is more willing to keep it in the hope that its price will rebound. As a result, the average stock position maintained in an investor's account registers below-market returns, while the positions that were exited actually beat the market.
This puzzling result has an equally puzzling interpretation. According to the study, individual investors possess valuable information with which to trade. This information takes a number of forms, including recent price history, industry or company fundamentals, and order flow. However, instead of using this information to their advantage, retail investors misinterpret it to the extent that they consistently exit the stocks they should hold, and hold the stocks that they are better off dumping.
One of the oldest trading adages is "Let your profits ride, and cut your losses short." Why is this advice so hard to follow? Chalk it up to human nature,. In all probability, we are probably wired to fail in the markets. The only way to succeed is to refuse to follow our instincts, which constantly bombard us with "A bird in the hand is worth two in the bush."
Next: Maintaining Discipline, Key To Stock Trading Success
