In their January 2005 paper entitled “Who Loses from Trade? Evidence from Taiwan”, Brad Barber , Yi-Tsung Lee, Yu-Jane Liu and Terrance Odean investigate wealth transfer between individuals and institutions in financial markets. Using a complete common stock trading history of all investors in Taiwan (the 12th largest financial market in the world) for 1995-1999, they document that:
- Individual investors underperform the market by 3.8% annually, equal to 2.8% of aggregate personal income for the nation. All losses incurred by individuals come from their aggressive trades (buy limit orders with low prices and sell limit orders with high prices, suggesting impatience). Individuals gain from passive trades at short horizons, but these gains erode (and even reverse) at long horizons.
- Four categories of cost contribute to the underperformance of individuals: trading losses (27%), commissions (32%), transaction taxes (34%) and market-timing losses (7%).
- Institutional investors outperform the market by 1.5% after commissions and transaction taxes. Most institutional gains come quickly from passive trades, providing liquidity to (uninformed) aggressive investors. The profits from aggressive institutional trades, suggesting informational advantage, develop over longer horizons.
- Most of the losses by individuals (and gains by institutions) occur within a few weeks of trades, continuing to accumulate for about six months. Half of the wealth transfer from individuals goes to foreign institutions.
The following charts, extracted from the paper, illustrate the relative performance of individual and institutional investors in Taiwan. While the active trading of Taiwanese individuals may creates greater mispricings than found in U.S. markets, differences in regulatory environments do not explain the above results.
In summary, individual investors are systematic stock trading losers; institutions, systematic winners. Individual investors may well be relatively overconfident (despite lack of investing education) and thrill-seeking compared to institutional investors.
