Chapter 15
INDIVIDUAL INVESTORS
Brad M. Barber and Terrance Odean
One half of U.S. households invest directly in common stocks or indi-
rectly through mutual funds and other managed assets, and one half of U.S.
households have self-directed retirement accounts such as individual retire-
ment accounts (IRAs), Keogh accounts, and 401 (k) accounts (Kennickell,
Starr-McCluer, and Surette 2000). The future welfare of these households
depends on their ability to make sound investment decisions. While it would
be convenient if all investors always made personally optimal decisions, they
do not. Investors err, and many would benefit from education and advice.
Financial advisors can more effectively help investors avoid common errors
if the advisors understand the decision processes that lead to these errors.
In this chapter we review research that we, and others, have done to bet-
ter understand the decision making of individual investors.^1 We focus
on two characteristic behaviors of individual investors and the decision bi-
ases that lead to these behaviors. First, we look at the “disposition effect”—
the tendency of investors to hold losing investments too long while selling
winners too soon. Secondly, we examine the propensity of many investors
to trade too actively. The disposition effect is one implication of Kahneman
and Tversky’s (1979) prospect theory. We believe that excessive trade is
due, at least in part, to investor overconfidence.
1.The Disposition EffectShefrin and Statman (1985) argue that if investors keep separate mental in-
vestment accounts (see Thaler 1985) and treat gains and losses as described
by prospect theory (Kahneman and Tversky 1979), they will tend to hold
onto their losing investments while selling their winners. Under prospect
theory, when faced with choices involving simple two- and three-outcome
lotteries, people behave as if maximizing an “S”-shaped value function (see
figure 15.1). This value function is similar to a standard utility function ex-
cept that it is defined on gains and losses rather than on levels of wealth.
(^1) This review is updated and revised from “The Courage of Misguided Conviction: Trading
Behavior of Individual Investors,” that appeared in the Nov./Dec. 1999 Financial Analysts
Journal.