Odd-Lot Traders: Past and Present Views by James A. Maccaro This article was originally published by Technical Analysis, Inc., and is copyrighted, 2004, by Technical Analysis, Inc., which reserves all rights. It is used with the permission of the original publisher. The Odd-Lot Theory can be summarized in five words: Most individual investors are dumb. Created in the 1930’s by a young man named Garfield Albee Drew and popularized in the 1940’s, its basic premise is that individual investors are as a group predisposed to buy high and sell low. Drew asserted that the typical non-professional investor is short-sighted, uninformed and more interested in a near- futile quest for quick profits than in finding enduring values. Hence, Drew proposed the trading strategy of tracking the actions of typical individual investors and doing the opposite. The Odd-Lot Theory has been described as the next best thing to finding the person who is always right, that is, finding the person who is always wrong and doing the opposite. During the first half of the 20th century, individual investors were likely to buy shares in “odd-lots,” that is, not in multiples of 100. Triple-digit share prices were common at that time because high nominal share prices were looked upon as a sign of a corporation’s stature and stability. Also, until after World War II, when both prosperity and inflation changed income levels, an annual salary of about $2,000 was considered amble for a middle class family. Therefore, even the purchase of a dozen shares of stock was a significant investment for the typical individual. Using data from the Brookings Institution and other sources pertaining to the period from May 1936 through 1940, Drew noticed a bias by individual investors in favor of buying (as opposed to selling), but he also noticed that the volume of odd-lot buying was lowest during stock market declines and highest when prices approached a peak. Hence, he concluded that “a change of sentiment on the part of the public after any market trend has become well established is always just the opposite of what it should be.” At the time he proposed the Odd-Lot Theory, Drew was employed by Babson’s United Business Service, where he went to work shortly after graduating from Harvard University. He popularized the theory in a 1941 book, New Methods for Profits in the Stock Market, which was a bestseller and led Time magazine to call him “the small investor’s Boswell.” This burst of attention allowed Drew to resign his job and begin his own investment advisory firm, which relied on the Odd-Lot Theory and operated into the 1960’s. In addition to the Odd-Lot Theory, Drew advocated buying growth companies, that is, companies with growing earnings, but he noted the difficulty of identifying such stocks and further warned against paying too high a premium for them. On the whole, he was not optimistic about the prospects of finding suitable growth firms, observing that “to invest most successfully in growth companies, one must recognize them for what they are, or will be, well ahead of the crowd and thus buy only at a reasonable price.” Although Drew had a low opinion of the ability of individual investors to pick the right stocks, he also did not put much faith in the opinions of professional analysts, noting that most did not foresee the Great Crash of October 1929 and were wrong about the markets throughout the 1930’s. Drew disparaged fundamental analysis (that is, investigating a corporation’s business health and prospects) because he believed that most investors --- individual or professional --- did not apply objective standards when investing. He asked “how high is high?” noting that stocks seemed “irrationally high” in 1927 but during the next two years they went much higher, and they seemed low in 1931 “but they soon sold at one-third of their average price of that year.” Today, odd-lot trading is less common among individual investors and it is far from clear that the basic premise of Odd-Lot Theory still holds true. Up to the creation of the Securities and Exchange Commission in the mid-1930’s, professional investors had an advantage over individual investors in that insider trading was common. Also, private individuals had much less access to information. Today, these advantages of wealthy individuals and institutional traders with regard to access to information are severely eroded. Moreover, today, institutional investors seem much more concerned with quick gains and appear as a group to be much less disciplined than individual investors. Even academics have come to acknowledge that individual investors can be successful stock pickers. A recent study by Joshua Covel, a professor at Harvard Business School, reported in the New York Times and elsewhere, concluded that one in five individual investors are able to consistently produce above-average stock market returns, while one in five almost always lose money (or had “negative ability”) and the remainder produce average returns. Arguably, stock market professionals can now be called the new “odd-loters,” that is, investors who are always wrong. This is reflected by the fact that mutual funds tend to hold the lowest levels of cash during market peaks, while they are likely to increase their cash holdings when prices are low. They also tend to buy or sell stocks as a herd, eager not to be left out when their peers gravitate towards a particular stock, but equally eager to dump stocks that have declines so that they do not have to be mentioned in the fund’s upcoming prospectus. In other words, they engage in the same type of behavior that Drew identified in the 1930’s, but from somewhat different motives. Likewise, it is well-known that the stock market tends to move in the opposite direction of the consensus of opinion expressed by professional market analysts in investment newsletters. Odd-Lot Theory is correct in proposing a contrarian approach to investing. But it appears that the point of reference when “going against the crowd” should be the actions of institutional investors and not private investors. |
Wall Street Cosmos
Research Report: Odd-Lot Theory