Wasted Effort

AS YOU MIGHT GUESS, my favorite Seinfeld episode is “The Stock Tip.” It starts with a conversation between George and Jerry.

“My friend Simons knows this guy Wilkenson,” George says. “He made a fortune in the stock market. Now he’s got this new thing.” George goes on to explain that Wilkenson has millions invested in a company called Centrax.

He urges Jerry to invest along with him, though the details are thin. “It’s an electronic thingy,” George says. But to underscore the opportunity, he tells Jerry that, “It’s gone up three points since I’ve been watching it.” He promises that Wilkenson will let them know “the exact right minute to sell.”

Jerry is skeptical but goes along. Almost as soon as he invests, however, the plan falls apart. The stock drops 50%, and Wilkenson disappears. As Jerry becomes increasingly agitated, his friends are no help.

George encourages Jerry to hang on but betrays his own fears. “I’m keeping it,” he says. “I’m going down with the ship!” Meanwhile, Kramer taunts Jerry with his usual nonsense: “It’s all manipulated, with junk bonds. You can’t win.” Then, raising his voice, “Get rid of that stock now!”

Unable to handle the stress, Jerry sells. That, needless to say, is when the stock turns around. As the episode wraps up, George gloats, cigar in hand. “I told you not to sell,” he tells Jerry. “Simons made money, Wilkenson cleaned up.” Meanwhile, Seinfeld is depressed. “I’m not an investor,” he says.

This episode aired more than 30 years ago. But according to the research, it’s remarkably close to reality. University of California at Berkeley professor Terrance Odean has been studying investment markets—and individual investors, in particular—his entire career. In a recent interview, he shared a set of useful observations and recommendations.

By way of background, Odean’s best-known study, co-authored with Brad Barber, was titled “Trading Is Hazardous to Your Wealth.” Today, it’s generally accepted that stock-picking is, for the most part, unproductive. But Odean and Barber were able to quantify it. Looking at actual client trades at an (undisclosed) brokerage firm, they found that investors who traded most frequently underperformed the overall market by more than six percentage points per year.

Why do active traders underperform? You might assume it’s because stock-picking is difficult. But that’s just one reason. Another factor is transaction costs. While trading commissions have largely dropped to zero, Odean points out that, “Zero commissions doesn’t mean zero profits to the brokerage firms.” Instead, he says, “They’re just getting paid by someone else.”

You may have heard the term “payment for order flow.” Wall Street market makers pay brokers to route trades through them. This gives them advance visibility into trades and thus potential price movements. This, in turn, gives market makers the opportunity to profit by placing their own trades a split-second before clients. For that privilege, market makers pay brokers substantial fees. In short, market makers are paying brokers for the ability to trade against the brokers’ clients. This comes out of individual investors’ pockets a penny or two at a time.

In addition, there’s what’s known as the bid-ask spread, the difference between the lower price at which you can currently sell a stock and the higher price at which you can buy. That too subtracts a fractional amount from each trade. This has always been a factor. But today, now that stocks no longer trade in eighths, most people view it as less of a concern.

Odean, however, points out that high-speed traders have swung the pendulum back. He cautions that individual investors should always ask themselves, “Who’s on the other side of this trade?” Most often, he says, the answer is a high-speed trading firm’s algorithm, designed to outwit individual investors. This is virtually impossible to observe with the naked eye, but research has proven that individual investors are jumping into a proverbial shark tank whenever they cross paths with Wall Street. This further contributes to the underperformance of those who trade most frequently.

This leads to another valuable insight. In his work, Odean has found that women, on average, achieve better investment results than men. No, it isn’t because women are better than men at picking stocks. Both underperform the market to the same degree with their picks. But women are more patient—they trade less. To the extent that each trade just makes things worse, women achieve results that are less bad.

Odean’s research has also explored the dynamics behind Robinhood—a new brokerage firm which pioneered the zero-commission model and which was closely associated with the meme stock craze we saw during the depths of the pandemic. Among other things, Odean and his coauthors found that Robinhood’s “gamification” of investing was both very successful and also very damaging. By simplifying the investing experience and making it more exciting—with confetti blanketing the screen after a trade, for example—Robinhood was remarkably successful. Starting from zero in 2013, it claimed 22 million customers by the end of 2021.

While Robinhood has done well as a firm, Odean found that its customers were especially susceptible to “herding events” and, as a result, experienced underperformance, on average. Odean connects the dots here in a way that provides an important lesson. Robinhood’s user interface gave customers the illusion that investing is a game. It was then natural for users to assume that, like any other game, practice would lead to greater skill and improved results. But as his earlier research had found, this is the opposite of what’s good for investors.

If you and I wake up every day and practice tennis or Tetris or Wordle or anything else, we’ll undoubtedly improve. But if we wake up every day and “practice” investing by trading, the opposite will likely occur. Investment returns will get worse. This reveals a key—and frustrating—reality about investing: Unlike pretty much every other activity in life, when it comes to investing, effort and results are inversely correlated. The harder we try, the worse our results. Effort has a negative payoff.

What does all this mean in practice? In my view, Odean’s research helps underscore a view I’ve emphasized before: For your long-term savings, stick with a simple set of broadly diversified index funds. By doing this, you’ll insulate yourself from the angst of watching individual stocks, and you won’t be tempted into buying and selling those stocks at inopportune times. A further advantage: Because good index funds are buy-and-hold investors themselves, they also help limit both transaction costs and taxes.

Despite these advantages, I know that when I recommend index funds, I run the risk of sounding like a killjoy. Picking stocks can be fun. And as I’ve noted before, it’s incontrovertible that all of the world’s great fortunes—from Carnegie and Rockefeller to Gates and Buffett— have been earned not with index funds but by owning one stock, albeit a very good one.

What’s the solution? In my work with clients, several maintain separate accounts in which they have placed more speculative bets—on individual stocks, on cryptocurrency and on startup companies. These accounts are limited in size and sit alongside their core index fund portfolios. Sometimes, they produce great profits and sometimes losses. But in all cases, they’re small enough to not disrupt the investor’s overall plan. Odean endorses this approach and perfectly summarizes the advantage: A small trading account like this offers investors “90% of the thrills for 10% of the cost.”

At the end of the “Stock Tip” episode, George leans in and lowers his voice: “Wilkenson’s got a bite on a new one,” he says. “Petramco Corporation… If you want to get in, there’s very little time.” This is funny and, of course, exaggerated. But if you find yourself in this situation, a side account may be the perfect solution.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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