TAKING SIDES: How online trading exploits investors

What drives most investment decisions?

The need to diversify? A detailed assessment of risk versus return? Profits?

Wrong.

It’s testosterone!

That’s the upshot of recent studies by Brad Barber and Terrance Odean, professors at the University of California Davis who examined the investing habits of 35,000 households.

According to the duo, psychological research has established that men are more likely to be overconfident than women are. As a result, they are apt to trade more and perform worse in the stock market.

In fact, their studies found that men trade 45% more than women do and earn annual risk-adjusted net returns that are 1.4% less than those earned by women. Single men fared even worse. They traded 67% more than single women and their risk-adjusted net annual returns were 2.3% less.

The findings are significant especially when viewed in conjunction with a separate study of trading and advertising by online brokerages, a subject that has come under heated discussion before the Securities and Exchange Commission.

Mr. Barber and Mr. Odean examined the trading activity of 1,607 investors who switched to online trading between 1992 and 1995. They found that young men with high incomes who preferred to dabble in small, high-risk growth stocks were the most likely to make the switch.

The researchers also found that the investors, after going online, traded more actively, more speculatively and less profitably than they did before. The same factors that drive investment decisions by men generally — overconfidence — was at the root of online trading decisions as well.

“We believe there is a simple and powerful explanation for high levels of trading on financial markets: overconfidence,” the authors conclude. “Human beings are overconfident about their abilities, their knowledge and their future prospects.”

Hubris

Judging from the study, the “irrational exuberance” that Federal Reserve Board Chairman Alan Greenspan made reference to a while back is very real.

Why blame it on men?

Because research over the years shows that they tend to be the most prone to overconfidence, especially if it involves a traditionally masculine task such as making investment decisions.

What’s most troubling about this is how advertising by online investing companies plays to and off of this predilection to overconfidence. It’s sort of like casinos making pitches to gambling addicts. Here’s a sampling contained in the study:

“Online trading is like the Old West,” warns Fidelity Investments in one ad. “The slow die first.”

“If your broker is so great, how come he still has to work?” asks E*Trade, noting in yet another ad that online investing is “a cinch, a snap, a piece of cake.”

“I’m managing my portfolio better than my broker ever did,” claims a middle-aged woman in a Datek Online commercial.

In Ameritrade’s “Momma’s Gotta Trade” ad, the study notes, two attractive suburban moms return from jogging. One runs right to her computer. A few clicks and an online trade later, one declares, “I think I just made $1,700.” Her kids cheer while the other laments, “I have mutual funds.”

“These advertisements entice and amuse,” the study states. “They assure the uninitiated that they have what it takes to trade online; tell them what to expect – sudden wealth; and what will be expected of them – frequent trades.”

It’s no coincidence that many ads feature women. The fact that they portray women successfully trading online directly challenges the masculinity of men, who typically make investment decisions. Those Madison Avenue types sure are sharp. They know how to push hot buttons.

But really, do those ads promote responsible investing? In light of the Barber and Odean studies, hardly.

Online firms are expected to spend more than $1 billion this year to lure new customers, which makes it “extremely difficult” for regulators to scrutinize ads for false or misleading claims, according to The Wall Street Journal.

The SEC wants a budget increase for Internet enforcement, a request currently pending in Congress. It would be money well spent.