Can Individual Investors Beat the Market?

We document strong persistence in the performance of trades of individual investors. Investors classiÞed in the top 10 percent place other trades that on average earn excess returns of 15 basis points per day. A rolling-forward strategy of going long Þrms purchased by previously successful investors and shorting Þrms purchased by previously unsuccessful investors results in excess returns of 5 basis points per day. These returns are not conÞned to small stocks nor to stocks in which the investors are likely to have inside information. Our results suggest that skillful individual investors exploit market inefficiencies to earn abnormal proÞts, above and beyond any proÞts available from well-known strategies based upon size, value, or momentum. ∗We thank Malcolm Baker, Randy Cohen, Laura Frieder, Mark Grinblatt, Mark Kamstra, Terry Odean, and seminar participants at the Atlanta Federal Reserve Bank, Harvard Business School, UCLA, the University of Florida, the University of Georgia, the University of Maryland, the University of Rochester, Virginia Tech, and the 2002 Western Finance Association Meetings for helpful comments and discussions, and Greg Allenby for his generous help with the data used here. Coval is at the Harvard Business School (jcoval@hbs.edu), Hirshleifer is at the Fisher College of Business at Ohio State University (hirshleifer 2@cob.osu.edu), and Shumway is at the University of Michigan Business School (shumway@umich.edu). Shumway acknowledges Þnancial support from the Bank One Corporation Assistant Professorship and the NTT fellowship of the Mitsui Life Center. Financial economists have debated the efficient market hypothesis (EMH) for decades. In most formal tests, econometricians measure the proÞtability of speciÞed strategies designed to exploit possible mispricing. Such tests are good at identifying whether a particular strategy represented a potential proÞt opportunity. However, such tests may fail to identify a market inefficiency if the econometrician has chosen a strategy that is unrelated to investor biases. Furthermore, such tests do not identify whether the proposed strategies were actually exploited, or even recognized by sophisticated traders at the time of their investments. Often econometricians employ Þnancial, econometric, and computational databases and technology that were not readily available to traders at the time. Thus, some authors have suggested that the traditional efficient market hypothesis is too strong, and have proposed milder notions of efficiency that reßect reasonable constraints on the ability of intelligent investors to process information (see, e.g., the adaptive efficiency argument of Daniel and Titman (1999)). In a similar spirit, we offer an approach for evaluating market efficiency that is based upon not just whether proÞt opportunities are in principle available, but whether some set of real investors have demonstrated abnormal skill in generating actual trading proÞts. Our evidence suggests that even this milder form of market efficiency is violated. According to the EMH, investors risk-adjusted performance should be random: unless they possess relevant private information, they should neither consistently beat the market nor should they, in the absence of transaction costs, consistently underperform the market. If those individual investors who have performed abnormally well in the past continue to perform abnormally well in the future by an amount that is not explained by mere chance, market efficiency may be violated. However, it is possible that investors whose abnormal performance persists are exploiting superior private information about fundamentals, rather than superior skill at identifying and exploiting market mispricing. Therefore, in addition to testing for performance persistence, we test whether abnormal performance is persistent among midto large-cap stocks, which presumably have less information asymmetry. In addition, we examine whether persistence of abnormal performance is conÞned to the few stocks in which investors transact frequently (and thus are more likely to possess private information) or whether it is present even in the companies in which our investors transact only once. Finally, we examine whether some investors persistently underperform; under an information story, such a Þnding would, implausibly, require investors to have superior information and then trade the wrong way. For example, although historical price data is in principle public information that is costlessly available to all, in reality such data is costly, as evidenced by the fees researchers pay for access to electronic databases. Investors who systematically underperform might at Þrst seem to present a paradox for the market inefficiency theory as well. On the one hand they display a superior skill at identifying inefficient prices,