“Behavioral finance” is the study of human behavior and how that behavior leads to investment errors, including the mispricing of assets. The field has gained an increasing amount of attention in academia over the past several decades as pricing anomalies have been discovered.
The basic hypothesis of behavioral finance is that, due to behavioral biases, investors/markets make persistent mistakes in pricing securities. An example of a persistent mistake is that investors/the market underreacts to news—both good and bad news are only slowly incorporated into prices.
My book “Investment Mistakes Even Smart Investors Make and How to Avoid Them” covers 77 mistakes, most of which are related to behavioral errors (others are simply due to lack of knowledge).
Recent Research
Mengqiao Du, Alexandra Niessen-Ruenzi and Terrance Odean contribute to the literature on investor behavior with their September 2018 study “Stock Repurchasing Bias of Mutual Funds.” Instead of examining the behavior of individual investors (often considered “dumb” retail money), their paper investigates the behavior of mutual fund managers (typically considered “smart” money—better trained and thus able to exploit the pricing mistakes of retail investors). While they may be better trained, they are still human, and perhaps still subject to the same type of behavioral errors made by individual investors.
The authors examined whether past positive or negative experiences a fund manager had with a particular stock are predictive for the stock being repurchased.
They hypothesized that “selling a stock for a gain is associated with positive emotions such as pride and happiness, while selling a stock for a loss is associated with negative emotions such as regret and disappointment. In an effort to repeat the positive emotional experience and avoid the negative one, mutual fund managers may be more prone to repurchase a stock that they sold for a gain (i.e., a past ‘winner’), while they may be less prone to repurchase a stock that they sold for a loss (i.e., a past ‘loser’).”
The study covered U.S. mutual funds over the period 1980 to 2014. The following is a summary of their findings:
Conclusions
These findings led the authors to conclude that “investors should be aware that mutual fund managers’ repurchasing decisions can be biased and eventually may hurt their performance.” Their findings, which were statistically significant at high confidence levels, should not come as a total surprise. After all, fund managers are human too, and thus subject to making at least some of the same behavioral errors individual investors make. Among them are home bias and overconfidence.
The body of evidence makes clear that institutional investors are subject to at least some of the behavioral errors attributed to individual investors—providing you with yet another reason to favor the use of only passively managed funds (such as index funds) that, by definition, are not subject to these trading behaviors.
Check out a short preview of Larry Swedroe and Kevin Grogan’s newest book, “Your Complete Guide to a Successful and Secure Retirement,” due out Jan. 7, 2019.
This commentary originally appeared November 2 on ETF.com
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