Why women make better investors than men

Ask a roomful of people if they think they are above-average drivers, and most will raise their hands. 86% of Harvard students say they are better looking than their classmates, and 68% of lawyers believe their sides will win1. Mathematically of course, it's impossible for more than half of any population to be above-average yet for as long as psychologists have been exploring human nature people have rated their own abilities above average on almost every desirable trait from effectiveness to sense of humour.

Optimism is a very healthy quality. It fuels us. Optimism is integral to the development of the human race because it helps us combat life's uncertainties, motivating us to persist, inspiring us to perform, and ultimately driving success in many areas of life. We're built to be optimistic - our brains have evolved to recall successes more easily than failures. But while optimism reflects a general belief, a general faith in the future, it's not to be confused with overconfidence, a particular trait which relates to the accuracy of specific forecasts or evaluations. While overconfidence doesn't necessarily imply arrogance, it is caused by the failure to accurately assess and interpret information - we're said to be overconfident if we demonstrate high confidence in an answer that turns out to be wrong. The obvious danger is that by being overconfident about an inaccurate evaluation, we're likely to make a flawed decision. Overconfidence is rife in tasks involving forecasts with low predictability and where feedback is not immediate: psychologists have found evidence of overconfidence in physicians, engineers, entrepreneurs, lawyers and negotiators, and it's particularly rampant - and destructive - in investing.

A Northwestern University survey asked investors how their portfolio had performed relative to Standard & Poor's 500-stock index. Nearly half thought they'd beaten the market by at least 5%, yet crunching the actual results revealed that 88% of investors had overestimated their returns, and a quarter of those who thought they'd beaten the market were actually 15% behind it.

A Wall St Journal Survey2 revealed that the average investor anticipates beating the market by at least twenty-five percent, yet an extensive nineteen year analysis3 by Dalbar, a American financial services consultancy, shows that the average investor achieves less than forty percent of the returns offered by markets. The danger is that in miscalibrating progress and mistakenly thinking they're doing better than they really are, overconfident investors end up insufficiently prepared for the future. For example, in a recent study over 80% of parents said they had a financial plan, and 75% were confident about their long-term financial well being - but a closer examination revealed less than forty percent were actually saving for their children's education, and a mere nine percent had financial plans that addressed even basic issues of investment, budgeting, insurance and wills.

Studies show that overconfidence is highest in the early stages of an investor's career4. By too easily recalling successes, and by failing to sufficiently weight failures, overconfident investors overestimate the precision of their own evaluation of an investment, and inadvertently end up underestimating risks and overrating their ability to control events. This unwarranted confidence creates a tendency to invest in direct stocks (rather than opting for the inherent diversification of mutual funds), to take too much risk, and to trade more frequently. The problem is that investors who trade the most are proven to achieve by far the worst results.

A startling analysis5 of ten thousand individual investors trading stocks from 1987 to 1993 showed that stocks these investors sold went on to beat the market, while those they bought and kept underperformed it. (See chart, left)

The average individual trader turns over about 80% of their stock portfolio annually5. The average mutual fund turns over at a slightly lower rate, and the individuals and mutual funds which are most overconfident (and therefore trade the most) earn the lowest returns6. Better investors and better mutual funds trade less and earn more. Simply put, overconfidence leads to counterproductive trading. As Terrence Odean says, "Trading is hazardous to your wealth".

One of the most interesting aspects of overconfidence is seen in gender differences. Overconfidence is bred by positive recall bias (the ability to more easily recall successes than failures), and studies7 show that women more easily remember failures (negative recall bias) than do men. While both men and women can be overconfident, research8 shows that in tasks perceived to be the masculine domain - such as finance - women calibrate themselves more harshly than men and expect to be less competent than they really are (which is probably why far more men than women are drawn to the financial industry. Ironically, an extensive study showed that women fund managers have produced on average better results than men11). A 1998 analysis9 of men's and women's portfolios showed that while both sexes had a similar investment mix, 58% of men believed they'd made money during the year as opposed to only 36% of women. In 2000, a Gallup Survey found that while both men and women expected their own portfolios to outperform the market, men expected theirs to outperform by a greater margin. "Both men and women detract from their returns by trading," says Terrence Odean. "Men simply do so more often." Being more overconfident than women in financial matters, men tend to overestimate their performance, spend more time and money on security analysis, make more transactions, and anticipate higher returns10.

The more overconfident an investor is, the more frequently they will buy and sell stocks - which is why men trade 45% more than women12. A groundbreaking study of investment behaviour by Terrance Odean is extremely revealing: while both men and women reduce their net returns through trading, men's more frequent trading takes its toll: men underperform women by 1.4% per year. "Men", says Odean, "often believe they know more than they do, which leads them to trade excessively, reducing their returns. Those who trade the most realize, by far, the worst performance". Single men are the worst culprits, trading 67% more and earning 2.3% per year less than single women.

The internet bubble contains many examples of classic behavioural mistakes. One of my favourite comes from Henry Blodgett, (yes, a male) who, before being expelled in disgrace from Merrill Lynch, spearheaded the championing of the 'new economy' and of internet stocks in particular. It was in January 2000, just a few short months before the technology collapse, when he overconfidently argued in favour of a continuing rise in internet stocks, declaring, "Valuation is often not a helpful tool in determining when to sell hypergrowth stocks." The rest is history.

The doctrines and principles of modern finance are based on the theoretical assumption that investors always behave rationally, but this is not always the case in real life. Our human psychology impacts our financial decisions, causing us to sometimes behave in ways that are 'irrational' in the classical economic sense. The field of Behavioural Finance explains the psychology of investing - how people make financial decisions in the real world, rather than in theory. It shows why we do what we do - what makes us tick financially - by looking at economics through the eyes of a psychologist. Behavioural Finance demonstrates observable, systematic and very human deviations from the neo-classical definition of 'rational' - and overconfidence is a clear example. By misinterpreting the accuracy of their assimilated information and overestimating their skill in analyzing this information, overconfident investors unconsciously indulge in excessive trading - which leads to exaggerated risk-taking, unnecessarily high transaction costs and, ultimately, sub-par investment returns.

The keys to better investing lie in behaviour modification. Women need to develop a greater (and more realistic) confidence in their financial abilities, while men can instantly improve their performance by tempering their innate tendency toward overconfidence. Combining the merits of healthy optimism and the clarity of accurate self-awareness with an informed understanding of your own investor psychology is the most reliable way to secure an above-average financial future.

1. Daniel Kahneman and Amos Tversky: Behavioural Finance
2. Wall St Journal June 1998
3. Dalbar, Quantitative Analysis of Investor Behaviour 2003
4. Barber and Odean: The Courage of Misguided Convictions October/ November 1999
5. Barber and Odean - Trading is Hazardous to your Wealth, Journal of Finance, April 2000
6. Carhart 1997
7. Gervais and Odean 1998
8. Beyer & Bowden, 1977
9. Dalbar
10. (Lewellen, Lease, and Schlarbaum 1977).
11. Bliss &. Potter
12. Barber and Odean: Boys will be Boys: Gender, Overconfidence, and Common Stock Investment

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By Philippa Huckle, The Philippa Huckle Group