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May 02, 2014 at 08:52 PM
Terrance Odean is the Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley. He is a member of the Journal of Investment Consulting editorial advisory board, the Russell Sage Behavioral Economics Roundtable and the WU Gutmann Center Academic Advisory Board at the Vienna University of Economics and Business.
He has been an editor and an associate editor of the Review of Financial Studies, an associate editor of the Journal of Finance, a co-editor of a special issue of Management Science, an associate editor at the Journal of Behavioral Finance, a director of the University of California Berkeley’s Experimental Social Science Laboratory, a visiting professor at the University of Stavanger, Norway, and the Willis H. Booth Professor of Finance and Banking and Chair of the Finance Group at the Haas School of Business at UC Berkeley.
As an undergraduate at Berkeley, Odean studied judgment and decision making with the 2002 Nobel Laureate in Economics, Daniel Kahneman. This led to his current research focus on how psychologically motivated decisions affect investor welfare and securities prices.
Today I ask Terry what I hope are Five Good Questions as part of my longstanding series by that name.
1. How much can we really expect to do to overcome our behavioral and cognitive biases?
Someone once said to me, “We can’t control our initial reactions, but we can learn to control what we do next.”
Investors will always have cognitive biases. One approach to overcoming them is to practice recognizing biases when they manifest themselves and then adjusting our behavior. This is what Daniel Kahneman describes in Thinking: Fast and Slow as System 2 monitoring System 1.
Another approach to overcoming biases is to develop practices and systems that mitigate these biases. For example, if an investor—individual or professional —tends to cling to losing investments, he or she can adopt a rule of automatically selling losers after a predetermined loss. Would this be a perfect solution? Certainly not, but it could be a considerable improvement on current behavior.
2. Are professional money managers better at dealing with bias than everyone else?
Professional money managers have more opportunity to learn to control their investment biases than do individuals. Some learn. Some don’t.
One obstacle is that professional money managers often don’t take a careful look at their own behavior. I’ve been consulting for a company in Boston, Cabot Research, that has developed tools to help professional money managers systematically analyze their past trading decisions to identify biases that are hurting performance.
3. What are the main differences between individual investors and professional money managers?
Professional money managers devote their working lives to investing. Most individuals invest in their spare time.
Professionals work in teams, build institutional knowledge and make extensive use of computers. Individuals tend to trade on their own. They may have access to public databases, but usually lack the training to do basic analyses such as discounted cash flow valuations of companies.
It is difficult for professional money managers to consistently outperform the market by enough to justify their fees. It is even more difficult for individuals to outperform through skill (as opposed to luck) by enough to justify active trading.
4. What are the most common errors among individuals?
Underdiversification, holding onto losers, chasing winners, buying stocks that catch their attention, systematically ignoring important information, paying too little attention to fees and trading too much.
5. What are the most common errors among professionals?
