Classical theories of investment developed in the 1950s and 1960s were based on the idea that investors were rational when it came to making decisions about their money. But psychology is challenging the mathematical approach to understanding how the markets work. Academics such as Terry Odean and Brad Barber are shedding new light on the mind of the investor and their findings are alarming. Based at the University of California in Davis, Odean and Barber have studied the investment behaviour of nearly 90,000 American households over a 10-year period up to 1996. They found that investors have far too much faith in their own ability, churn their portfolios too much and hold on to losers too long.
Overconfidence is well known to psychologists.
Citing evidence in books such as Beyond Greed And Fear, by Hersh Shefrin, Odean points to numerous experiments that show people tend to overestimate their abilities in a wide range of activities. Statistically, of course, this is non- sense, because for some people to be above average, others must be below it. For private investors, overconfidence comes from picking one or two good stocks to begin with. This is easy and I'm good at it. That inevitably causes people to trade more than they should - to their cost.