Our Behavioral Biases Play a Major Role in Our Investing Success

The field of behavioral finance has provided us with fascinating insights into how our behaviors as human beings impacts investment results. Studies have helped us understand how we hold and trade stocks and mutual funds, and show how behavioral biases such as familiarity, overconfidence, narrow framing, trend chasing, the lottery effect, and home bias lead to poor decision making.

Traditional portfolio choice models imply a simple investment strategy based on well-diversified, low expense mutual funds and minimal portfolio rebalancing. Index and other low-fee, low-turnover equity funds are cheap, convenient vehicles for individual investors to implement such a strategy. The purpose of the study "Behavioral Biases of Mutual Fund Investors" was to test whether behavioral biases explain why the use of mutual funds varies substantially across individual investors and often departs from the simple strategies suggested by classic theories.

Using a database of tens of thousands of brokerage records of U.S. individual investors, the authors examined the effect of behavioral biases on the mutual fund choices of a large sample of U.S. discount brokerage investors. Their basic conclusion was that behaviorally biased investors typically make poor decisions about fund style and expenses, trading frequency and timing -- resulting in poor performance.

The following is a summary of their conclusions:

• Investors with strong behavioral biases or lack of attention to firm-specific or macro-economic news are less likely to hold mutual funds, or select mutual funds for the wrong reasons. When they do buy mutual funds, they trade them frequently, tend to time their buys and sells badly, and prefer high expense funds and active funds instead of index funds.
• Biased investors are more likely to chase fund performance, casting doubt on the idea that trend-chasing reflects rational fund selection decisions.
• These decisions are suboptimal because they're associated with lower overall returns.
• The average (median) market risk-adjusted return on an investor's portfolio of individual stocks is an unflattering -0.38 percent (-0.28 percent) per month.
• Interestingly, behavioral biases don't appear to affect the performance of index fund holdings.
• Despite the obvious diversification benefits offered by mutual funds, the proportion of mutual funds in a typical equity portfolio that includes mutual funds is less than 24 percent.
• The proportion of index funds in the aggregate mutual fund portfolio is very low, with a mean of only 6.5 percent. However, among investors who hold index funds, the proportion of index funds in the mutual fund portfolio is about 38 percent.

Gamblers Gamblers represent individuals who are:

• Less likely to use mutual funds
• Tend to select high-expense funds
• Are more likely to trend-chase, and suffer significantly inferior mutual fund portfolio performance as a consequence

Smart Smart describes investors with higher income, relatively higher educational level, and greater investment experience. It also represents individuals who are more likely to use mutual funds and benefit from their choices by choosing funds with low expense ratios or loads, and are less likely to trend-chase - and thus enjoy better performance.

Overconfident Overconfident describes investors who are poor decision makers, avoid participation in mutual funds and chase trends to an even greater degree than Gamblers. They also tend to select high expense, high load, and high turnover funds.

Narrow Framers Narrow Framers' mutual fund participation is about as bad as Gamblers' participation, though not as bad as those in the Overconfident category. Small holdings of mutual funds, selection of high expense funds, trend chasing and consequent poor performance are also evident, though milder than for Gamblers and Overconfident investors.

Mature Mature investors participate and hold mutual funds to a greater extent than our other stereotypes and avoid high-expense funds and trend chasing to an even greater extent than those in the Smart category. However, there are other elements of Mature investors decision making about mutual funds that yield significant negatives on other performance measures, negatively impacting performance.

This study contributes to what was an already overwhelming body of evidence demonstrating that most investors make poorly informed decisions impacted by both behavioral biases and ignorance. The authors suggest that "given the misuse of equity mutual funds, a public campaign to increase awareness of basic investment principles and the benefits and pitfalls of equity mutual funds is likely to help many types of individual investors make better decisions. Furthermore, the lack of attention to low cost or index funds suggests more explicit disclosure of fund expenses and turnover, perhaps even as prominent as the health warnings now displayed on packets of cigarettes. Finally, the reliance of mutual fund investors on broker-supplied information at the time a fund is selected and on delegated investment decisions afterwards suggests that even more explicit disclosure of fund characteristics be imposed on brokerage firms and fund managers."

Photo courtesy of Digital Shotgun on Flickr.
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