Odd-Lot Traders

ODD-LOT THEORY

The odd-lot theory has been described as the next best thing to finding the person who is always right: finding the person who is always wrong.

Triple-digit share prices were common in the 1920s and, to a lesser extent, 1930s because high nominal share prices were looked upon as a sign of a corporation's stature and stability. In addition, until after World War II, when both prosperity and inflation changed income levels, an annual salary of about $2,000 was considered ample for a middle-class family. Therefore, even the purchase of a dozen shares of stock was a significant investment for the typical individual.

Analyzing data from the Brookings Institution and other sources pertaining to the period from May 1936 through 1940, Drew noticed that individual investors were biased in favor of buying, 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 his theory in a 1941 book, New Methods For Profit 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 from his job and begin his own investment advisory firm, which relied on the odd-lot theory and operated into the 1960s.

FUNDAMENTALS?

In addition to the odd-lot theory, Drew advocated buying growth companies — that is, those 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. He observed, "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."

Drew had a low opinion of the ability of individual investors to pick the right stocks, nor did he 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 1930s.

He disparaged fundamental analysis, 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. Again, they seemed low in 1931 — "But they soon sold at one-third of their average price of that year."

DOES IT HOLD TRUE?

Today, odd-lot trading is less common among individual investors, and it is far from clear whether the basic premise of the odd-lot theory holds true.

Prior to the creation of the Securities and Exchange Commission in the mid-1930s, professional investors had an advantage over individual investors because insider trading was common. In addition, back then, private individuals had much less access to information. Today, the advantage of superior access to information that only wealthy individuals and institutional traders once enjoyed is severely eroded. Moreover, institutional investors now 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 stockpickers. A recent study conducted by Joshua Coval, a professor at Harvard Business School, concluded that one in five individual investors is able to consistently produce above-average stock market returns, while one in five almost always loses money (or has "negative ability"). The remainder produce average returns.

These days, stock-market professionals might be called the new "odd-lotters," investors who are always wrong. This is reflected in mutual funds, which tend to hold the lowest levels of cash during market peaks, and are likely to have increased cash holdings when prices are low. Mutual-fund managers also tend to buy or sell stocks as a herd, eager not to be left out when their peers gravitate toward a particular stock, but equally eager to dump declining stocks. In other words, they engage in the same type of behavior that Garfield Drew identified in the 1930s, but with 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.

The odd-lot theory is correct in proposing a contrarian approach to investing. But it appears that nowadays the point of reference when "going against the crowd" should be the actions of institutional investors, and not necessarily private investors.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, the Massachusetts Law Review, and other magazines. He can be reached at jam@juno.com.

RELATED READING

Hulbert, Mark [2003]. "Think you can beat the market? A study says 1 in 5 can," The New York Times: March 16.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.