Puzzling Investor Behavior

Investors engage in very curious behavior. It’s increasingly difficult to understand why this occurs. Here are some examples:

Returns chasing

“Returns chasing” describes activity by investors that typically involves dumping poorly performing mutual funds and replacing them with funds that have stellar recent returns.

This behavior makes no logical sense because there’s ample evidence that mutual fund performance doesn’t persist.

One study (discussed here) looked at the performance of 641 actively managed funds. A puny 0.3% of the top performing funds in 2012 stayed in the top quartile in March 2016. That means that 99.7% of top performing funds were unable to replicate their stellar performance only four years later.

YiLi Chien, Senior Economist at the Federal Reserve Bank of St. Louis, looked at quarterly stock mutual fund flow and return data from the Investment Company Institute for the period 2000-2012. He found chasing returns cost the average U.S. mutual investor about 2% a year “which is very significant.”

Chasing returns is great for brokers (more trading means more commissions) and for high-priced consultants to pension plans (who get paid for recommending which mutual funds to keep and which ones to dump). However, here’s sobering data that should cure you of this harmful behavior.

A study published in The Journal of Finance in 2008, authored by Amit Goyal and Sunil Wahal, examined 8,755 hiring decisions by approximately 3,400 plan sponsors over a 10-year period. These plans had access to the best and most highly compensated consultants. Yet the study found those fund managers who were fired subsequently earned returns higher than their replacements. The plan sponsors would have been better off keeping the poor performing fund managers and not hiring those with stellar recent performance.

Actively managed funds

While there has been a marked shift towards index funds, the majority of investors continue to purchase actively managed funds (where the fund manager attempts to “beat” the returns of a designated benchmark). This is the most puzzling behavior of all, because it makes no objective sense.

A working paper published by three Harvard economists framed this issue this way:

“The mutual fund industry presents a major challenge to financial economics. It is enormous, supervising around $7 trillion of investor assets. It includes thousands of competitors, who nonetheless charge high fees and remain highly profitable. Perhaps most strikingly, it appears to provide no economic value to investors, with virtually all mutual funds underperforming by a significant margin passive investment strategies offered by low-fee index funds (Swensen 2005). (my bold and italics).

The authors of the study found actively managed funds were masters of persuasion (not investing!). They didn’t advertise high fees. They reported past performance when it was good, and omitted it when it was bad. They reported data on their purported expertise “even when these data are objectively uninformative.”

Accurate advertising would tell you (as Vanguard does) that low fees are the only factor that correlate with higher expected returns. A comprehensive analysis by Morningstar reached this conclusion (reported here). It found: All told, cheapest-quintile funds were 3 times as likely to succeed as the priciest quintile.

Hopefully, understanding how you are being duped by the securities industry will solve the poor investment decision puzzle.

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