Dave, have you ever been in a new town and found yourself choos-
ing between two restaurants? One perfectly rational way of deciding, if
they are close in distance, is to see which restaurant is busier since
there’s a good chance that at least some of those patrons have tried both
restaurants and have chosen to eat at the better one. But when you eat at
the busier restaurant, you are increasing the chance that the next diner,
using the same reasoning, will also eat there, and so on. Eventually,
everybody will be eating at that one restaurant even though the other
one could be much better.
Economists call this decision-making process an information cascade,
and they believe that it happens often in financial markets.^10 For exam-
ple, when one company bids for another, often other suitors will join in.
When an IPO gets a strong following, other investors join in. Individuals
have a feeling that “someone knows something” and that they shouldn’t
miss out. Sometimes that’s right, but very often that is wrong.Excessive Trading, Overconfidence, and the Representative BiasIC:Dave, let me shift the subject. From examining your trading records,
I see that you were an extremely active trader.
Dave:I had to be. Information was constantly bombarding the market; I felt
I had to reposition my portfolio constantly to reflect the new information.
IC:Let me tell you something. Trading does nothing but cause extra anx-
iety and lower returns. A couple of economists published an article in
2000 called “Trading Is Hazardous to Your Wealth.” (And, I may add, to
your health also.) Examining the records of tens of thousands of traders,
they showed that the returns of the heaviest traders were 7.1 percent
below those who traded infrequently.^11
Dave:You’re right. I think trading has hurt my returns. I thought that I
was one step ahead of the other guy, but I guess I wasn’t.
IC:It is extraordinarily difficult to be a successful trader. Even bright
people who devote their entire energies to trading stocks rarely make
superior returns.CHAPTER 19 Behavioral Finance and the Psychology of Investing 325
(^10) Robert Shiller, “Conversation, Information, and Herd Behavior,” American Economic Review, vol.
85, no. 2 (1995), pp. 181–185; S. D. Bikhchandani, David Hirshleifer, and Ivo Welch, “A Theory of
Fashion, Social Custom and Cultural Change,” Journal of Political Economy, vol. 81 (1992), pp.
637–654; and Abhijit V. Banerjee, “A Simple Model of Herd Behavior,” Quarterly Journal of Econom-
ics, vol. 107, no. 3 (1992), pp. 797–817.
(^11) Brad Barber and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock In-
vestment Performance of Individual Investors,” Journal of Finance, vol. 55 (2000), pp. 773–806.