Overconfidence and overtrading

What the research found about overconfidence and overtrading, how turnover costs compound, and simple checks investors and traders use to trade less.

Part of the Psychology and Discipline track on Agenticks. About 10 minutes, written for a intermediate reader.

Read first: Cognitive biases in investing and trading, Fees, commissions, and the real cost of trading.

Last reviewed .

Key takeaways

Overconfidence is believing your knowledge, skill or forecasts are more accurate than they really are. A few good calls in a row can make it feel like skill, even when luck did most of the work. The trouble is that confidence is cheap to feel and expensive to act on: every trade pays a spread, often a commission, and sometimes slippage. If the edge behind a trade is imagined, those costs are the only certain part of the result. Overtrading is what overconfidence looks like in an account: trading more often than your plan or your evidence supports. It is common to long-term investors who tinker with a portfolio and to day traders who take every move that looks interesting.

What the research found Brad Barber and Terrance Odean studied 66,465 households with accounts at a large U.S. discount broker from 1991 to 1996. The average household turned over 75% of its portfolio a year and earned 16.4% a year after costs, while the market earned 17.9%. The fifth of households that traded most, with turnover above 250% a year, earned 11.4%. The most telling detail is what happened before costs. Frequent and infrequent traders earned very similar gross returns. After costs, the frequent traders earned 11.4% and the infrequent traders 18.5%. The extra trading did not find better stocks. It mostly bought costs. The authors' explanation was overconfidence, and their title said it plainly: trading is hazardous to your wealth. Those were unusually strong years for U.S. stocks, and past returns do not guarantee future ones. The lesson is not the level of returns but the gap that costs opened up.

A year later the same authors tested the overconfidence explanation directly. Psychology research finds men tend to be more overconfident than women in areas such as finance, so they compared the two using account data for over 35,000 households. Men traded 45% more than women, and trading reduced men's net returns by 2.65 percentage points a year, against 1.72 points for women. The finding is about overconfidence and how often people trade, not about who is better at picking investments.

Activity is not the same as skill

Trading more feels like doing more. But a trade only adds value if the edge behind it is bigger than its cost. When the edge is uncertain, the cost is the one part of the result you can count on.

Why overconfidence survives losses If overtrading costs money, why do people keep doing it? Part of the answer is how results get explained. A winning trade feels like proof of skill. A losing trade feels like bad luck, a stop that was "hunted", or news nobody could have seen. Hindsight makes the winners look as if they were obvious to you all along, which inflates confidence further, as the lesson on cognitive biases describes. The other part is that short-run results are noisy. Over twenty trades, a strategy with no edge at all can easily show a profit, and a sound one can show a loss. Our lesson on variance, luck and skill shows how long it takes for skill to separate from luck. Until then, a good month mostly tells you that you had a good month. Some signs that activity has run ahead of evidence: You trade on most days, whatever the market is doing. You cannot name the setup behind a large share of your trades. Your number of trades rises after losses, or after a winning streak. You know your profit and loss for the month but not your total costs.

Worked example: what turnover costs over 20 years

A $50,000 portfolio is assumed to grow 5% a year before costs, an assumption and not a forecast. Each trade is assumed to cost 0.25% of the amount traded, counting spread and commission. Selling and then buying the same amount means each 1% of turnover trades 2% of the portfolio.

Low turnover: 10% a year ($5,000 sold + $5,000 bought)$10,000 traded
Cost at low turnover ($10,000 x 0.25%)$25 a year (0.05%)
High turnover: 250% a year ($125,000 sold + $125,000 bought)$250,000 traded
Cost at high turnover ($250,000 x 0.25%)$625 a year (1.25%)
After 20 years at low turnover (5% less 0.05%, compounded monthly)$134,288
After 20 years at high turnover (5% less 1.25%, compounded monthly)$105,726
Gap left by trading costs$28,562, about 21% less

Illustrative numbers. Real costs vary by market, broker and order type, and returns are not steady.

Try it: turnover as a yearly cost

Enter a yearly trading cost at two levels of activity. The default return is an assumption of 5% a year before costs, not a prediction.

The day trader's version For an active futures or stock trader, costs arrive per trade rather than as a yearly percentage, which makes them easy to ignore. Suppose each round trip costs $3.25 in commissions, fees and a little slippage (an illustrative figure). Ten trades a day for 250 trading days is 2,500 trades, or $8,125 a year per contract or unit traded, before a single trade is judged on its merits. Our lessons on fees and costs and the reality of day trading go further into what that does to results.

Driven by the plan
An entry that matches a written setup, sized from the stop, Stopping for the day because the daily loss limit was hit, Rebalancing to target weights on the scheduled date
Driven by overconfidence or impulse
A second trade taken straight away to win back a loss, Doubling size because the last three trades won, Buying because the market feels like it is about to move

Simple checks on overtrading Count. Know how many trades you made last month and what they cost in total. Most people underestimate both. Cap. A maximum number of trades per day, or a minimum holding period for an investment, puts a speed bump in front of impulse. Compare with doing nothing. Each quarter, compare your result with simply holding what you started with. If the extra activity did not beat it after costs, the activity was the cost. Write the reason first. A trade that cannot be explained in one sentence before entry is usually an impulse. The next lesson shows how a trading journal makes that reason, and the count, automatic.

You can spot overtrading

You can now explain what the research found about overconfidence and trading frequency, work out what turnover costs, and use simple checks to trade less.

Check your understanding

In Barber and Odean (2000), how did households that traded frequently compare with those that traded rarely, before costs?
Their gross returns were very similar. The paper found little difference before costs. After costs, frequent traders earned 11.4% a year and infrequent traders 18.5%, so trading costs made the difference.
What does a portfolio turnover of 250% a year mean?
Trades worth about two and a half times the portfolio's value were made in the year. Turnover compares the value traded with the size of the portfolio over the period.
Why did Barber and Odean (2001) compare men and women?
Psychology research finds men more overconfident in finance, so it was a test of whether overconfidence drives trading. Gender was used as a proxy for overconfidence. Men traded 45% more, and trading cut their net returns by 2.65 percentage points a year against 1.72 for women.
Which is a trade driven by the plan rather than by overconfidence or impulse?
An entry that matches a written setup, sized from the stop. It follows rules written before the moment, so it is a planned trade whatever its result.

Common questions

What is overtrading?
Overtrading is trading more often than your plan or your evidence justifies, often after losses, after a winning streak, or out of boredom. Each extra trade adds costs, so overtrading tends to lower returns even when the trades themselves are not obviously bad.
Does trading more often lead to lower returns?
In a large study of brokerage accounts from 1991 to 1996, the most active fifth of households earned 11.4% a year after costs, against 17.9% for the market and 18.5% for the least active households. Gross returns were similar; costs made the difference.

Terms defined in this lesson

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Written and reviewed by the Agenticks Learn editorial team. How we write and check lessons.

Agenticks Learn is general education. It is not financial, investment, tax or legal advice, it does not take your situation into account, and nothing on it is a recommendation to buy, sell or hold any security or to open any account. Examples use illustrative numbers. Investing involves risk, including losing money you put in, and past performance does not predict future results. Tax rules and limits change; the official sources linked in each lesson are the final word.