Behavioral Biases of Mutual Fund Investors

Behavioral Biases of Mutual Fund Investors

Warren Bailey, Alok Kumar, David Ng

7-2010 Journal of Financial Economics

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Our evidence shows that investors who score high on behavioral biases tend to invest in funds with higher expense ratios and loads. They experience poor investment performance as a result.

In his American Finance Association presidential address, Gruber (1996) notes several puzzling aspects of individual portfolio allocation decisions. He speaks of “sophisticated” investors who make decisions based on performance and “disadvantaged” investors who are susceptible to sales pressure or constrained by tax or institutional issues. In his presidential address, Campbell (2006) suggests that naïve investors may subsidize sophisticated investors in financial products such as mortgages. Our results echo the spirit of these ideas. A complex set of factors, some rational and some behavioral, appear to drive investors’ stocks versus funds decisions and their mutual fund choices after they decide to invest in mutual funds. Some types of investors appear to make effective choices that enhance portfolio performance, while others do not.

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.” Click here for the original paper