Overconfidence Sidestepped

By Louis Corrigan (TMFSeymor)

ATLANTA, GA (April 23, 1999) -- Yesterday, Fool Editorial received an email from someone claiming to have found a market-timing indicator that's "90% plus accurate." Our correspondent claimed that since she had started using this miraculous indicator, "I have been running over 150% per year in profit. Beat that!"

How's 199%? That was the Rule Breaker's return for 1998. And with the portfolio up 74% after less than four months of 1999, this sucker's on a pace to do even better this year!

OK, so that's not likely to happen. Heck, this portfolio could do nothing for the rest of the year, and the portfolio managers would still be beaming. Beaming! It could lose half its year-to-date gains with no sweat off their brows. In fact, it nearly did that earlier this week and yet it was still kicking the butt of nearly every professional money manager in America. Of course, your average mutual fund annually turns over about four of every five stocks it owns. Here today, gone next quarter.

In the last four days, though, the Rule Breaker has snapped back, better than ever. All that dire talk Monday of "inflection points" designed to make you shift your cash from one sector to another quickly proved to be hogwash. The leading Internet issues once again thumbed their noses at the eggsperts and rallied back to new highs, carrying the Rule Breaker port along for the ride. Yippee!

Lest you think I'm gloating, I'm not. I have zero to do with managing this portfolio. As an outside observer, though, I think one's got to be both pretty darn impressed by this portfolio's performance as well as determined to learn the lessons it offers. And perhaps the most important lesson, aside from the actual stock picking (which has been increasingly stellar), is that you've got to learn to be an owner, not a trader. Learn to buy businesses rather than trade shares.

Could a market-timing indicator have helped the Rule Breaker bail out of America Online (NYSE: AOL) and the other Internet names last week before they plunged -- and then flashed "Strong Buy" at the market lows Monday? I doubt it, but frankly, who cares? By staying with great companies and ignoring the "inflection point" paranoia, the Rule Breaker has added to its paper profits while postponing taxes, avoiding unnecessary trading costs, and letting its managers have a life. Well, at least sorta.

The best empirical data on the subject reveal that individual investors underperform the market solely because they trade too much. Indeed, as I've reported before, analysis performed by University of California-Davis business school professors Terrance Odean and Brad Barber on data from thousands of actual individual investors shows that the most active traders tend to underperform the market averages most sharply. That's without even figuring in taxes!

The converse is also true. Odean and Barber found that investors who kept their annual portfolio turnover to a minimum had an excellent shot at meeting or beating the market. Of course, their data doesn't factor in how much the Fool's brilliant commentary -- both from us writers and from thousands of you readers contributing to our message boards -- can improve your stock picking! So I'm willing to bet that bonafide Fools, as a group, are doing even better than the Odean-Barber studies suggest

Our B-school profs argue, though, that a central reason active trading does poorly compared to buy-and-hold is that trading gives free reign to the common problem of overconfidence. By racing in and out of stocks trying to time market movements, traders are betting that they know better than the market when a zig will become a zag. At the same time, our profs have found that investors are far more reluctant to sell a stock for a loss than for a gain, probably because it's a lot harder for people to admit they were wrong than to celebrate a victory.

This is really just overconfidence and its evil twin (the reluctance to confront one's overconfidence) in action. But it leads to ugly investment results. Consider Odean's finding that "the winning investments investors choose to sell continue in subsequent months to outperform the losers they keep." Tell me that ain't true!

Though our market-timing correspondent was female, the fact is that women actually tend to be better investors than men, largely because they trade less frequently, as Selena Maranjian reminded us in last week's Dueling Fools. Ironically, this seems to have a lot to do with the fact that men in our culture tend to be more confident than women. For men, such confidence, eh, overconfidence actually becomes a handicap in investing.

Barber and Odean found, for example, that men trade 45% more than women and yet they "earn annual risk-adjusted net returns that are 1.4% less than those earned by women." This disparity is even more pronounced for single men and women. The profs found that "single men trade 67% more than single women and earn annual risk-adjusted net returns that are 2.3% less than those earned by single women."

Their quote from Josh Billings, a 19th-century humorist, sums up the Odean-Barber findings quite nicely: "It's not what a man don't know that makes him a fool, but what he does know that ain't so." Or, our version: "It's what a woman knows that she don't know that makes her a Fool."

These gender distinctions, of course, are pretty much culturally fluid. Repeating these studies 20 years from now, some academic will no doubt find that the trading habits of men and women have become more alike. At the same time, the active traders, male or female, will still underperform the less active traders.

In any case, we need to celebrate buy-and-hold Foolish investing after another week when slothful inaction allowed the Rule Breaker to ignore panic and produce a 5.46% gain, nearly doubling the S&P's 2.87% gain and staying ahead of the mighty Naz, which pushed ahead 4.29%. For the day, the Rule Breaker crushed the averages, rising 4.37% while the S&P and Dow lost ground and the Naz inched up just 1.14%.

Our biotech Amgen (Nasdaq: AMGN) bounced ahead $2 5/16, rebounding from two days of selling connected to projections of slowing Epogen sales. More interesting, @Home (Nasdaq: ATHM) raced ahead $13 1/16 as everything cable rose on news of AT&T's (NYSE: T) surprise $58 billion offer to acquire MediaOne Group (NYSE: UMG), as reported in today's Breakfast with the Fool. The proposed deal suggests that competition for the last mile of telephone traffic is seriously heating up and that broadband is, indeed, where it's at.

Much of the port's remaining action took place on the I-Net front. That's no surprise given that next week brings earnings news from eBay (Nasdaq: EBAY) on Monday, AOL on Tuesday, and Amazon.com (Nasdaq: AMZN) on Wednesday. AOL closed down $2 3/16, after dipping even further during the day. Though the stock had a terrific week, ending 31% above its Monday low of $112, yesterday's news that Sprint (NYSE: FON) plans to sell 28.8 million AOL shares may have dampened investors' spirits. Though it's not a huge big deal, you never like to see large, presumably savvy investors cashing out major holdings, no matter how reasonable the reason.

Meanwhile, eBay announced its new personal shopper feature, a free service that automatically sends customers an e-mail when items of specific interest to them are registered for auction. This win-win electronic feature should provide eBay customers with added service while spurring repeat business. Got to love the Internet! However, with eBay spurting ahead $28 1/8 to a new all-time high and Amazon splashing up $20 1/16 to its own new all-time high, one has to figure some investors are simply climbing aboard in preparation for what will no doubt be strong quarterly reports next week.

With that, be sure to check out our Wade Cook expos� as you enjoy a terrific weekend.

What's up with Harry Jones today?

04/23/99 Close

Stock  Change    Bid 
AMGN  +2 5/16    65.13
AMZN  +20 1/16  210.13
AOL   -2 3/16   146.38
ATHM  +13 1/16  158.50
CAT   +  3/4     60.56
CHV   -2 5/8     95.88
DD    +  13/16   66.94
DJT   +  5/16     4.44
EBAY  +28 1/8   200.13
GT      ---      55.63
IOM   +  1/16     5.13
SBUX  -  3/4     32.00
TDFX  -  1/16    18.81

                  Day     Month  Year   History   Annualized 
      R-BREAKER  +4.37%   9.74%  74.41% 1650.60%  83.52%
        S&P:     -0.15%   5.48%  10.70%  209.56%   27.08%
        NASDAQ:  +1.14%   5.24%  18.15%  259.73%   31.20%

    Rec'd    #  Security     In At       Now      Change
   8/5/94  2200 AmOnline       0.91    146.38   16005.52%
   9/9/97  1320 Amazon.com     6.58    210.13    3093.76%
  5/17/95  1960 Iomega Cor     1.28      5.13     300.26%
  12/4/98   450 @Home Corp    56.08    158.50     182.63%
  2/26/99   300 eBay         100.53    200.13      99.08%
 12/16/98   580 Amgen         42.88     65.13      51.90%
  4/30/97 -1170*Trump*         8.47      4.44      47.60%
  2/23/99   300 Caterpilla    46.96     60.56      28.95%
  2/23/99   180 Chevron       79.17     95.88      21.10%
   7/2/98   470 Starbucks     27.95     32.00      14.47%
  2/23/99   290 Goodyear T    48.72     55.63      14.18%
  2/20/98   260 DuPont        58.84     66.94      13.75%
   1/8/98   425 3Dfx          25.67     18.81     -26.71%

    Rec'd    #  Security     In At     Value      Change
   8/5/94  2200 AmOnline    1999.47 322025.00  $320025.53
   9/9/97  1320 Amazon.com  8684.60 277365.00  $268680.40
  12/4/98   450 @Home Corp 25236.13  71325.00   $46088.87
  2/26/99   300 eBay       30158.00  60037.50   $29879.50
 12/16/98   580 Amgen      24867.50  37772.50   $12905.00
  5/17/95  1960 Iomega Cor  2509.60  10045.00    $7535.40
  4/30/97 -1170*Trump*     -9908.50  -5191.88    $4716.63
  2/23/99   300 Caterpilla 14089.25  18168.75    $4079.50
  2/23/99   180 Chevron    14250.50  17257.50    $3007.00
  2/20/98   260 DuPont     15299.43  17403.75    $2104.32
  2/23/99   290 Goodyear T 14127.38  16131.25    $2003.88
   7/2/98   470 Starbucks  13138.63  15040.00    $1901.38
   1/8/98   425 3Dfx       10908.63   7995.31   -$2913.31

                              CASH   $9924.87
                             TOTAL $875299.56

Note: The Rule Breaker Portfolio was launched on August 5, 1994, with $50,000. Additional cash is never added, all transactions are shared and explained publicly before being made, and returns are compared daily to the S&P 500 (including dividends in the yearly, historic and annualized returns). For a history of all transactions, please click here.


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