Mutual funds: Seeing is not believing

Q I recently read in a study that over a 10-year period, the average investor lagged almost 11% behind the actual performance of the same mutual fund. How can this be?

John J. Grande, CFP; Traudy F. Grande, CFP; and John S. Grande, CFP

A: Investor behavior seems to account for most of this difference. Getting in and out of a mutual fund at the wrong time is generally accounted for by the psychology behind an investor's behavior. One way to better understand this phenomenon is to examine an investor's motivation for changing positions. Although greed and fear are still the major components to buy and sell activity, it is important to look at why they perceive risk and reward the way they do.

Rational minds can act irrationally

Figure 1 These drawings prove that perceptions can be affected by the way information is presented. Investors must identify and counteract illusions for success.

The first of the three images in Figure 1 contains two tan circles. Which one is larger? Although the one on the left may appear to be larger, they actually both are the exact same size. When looking at the middle image, which tan bar is longer: the top bar or the bottom one? Most people will claim the top bar is longer when in fact it is not. The two bars are identical in length. Are the tan horizontal lines straight or crooked in the last image? Although they may seem crooked, they are actually straight.

When the images are presented in this new format, our perception changes. This shift tells us that we cannot rely on our perceptions, intuitions, or gut feelings alone. It also has been shown that investors tend to rely on their perceptions, making the same investing mistakes over and over. Fortunately, studies by some of the leading academics in the field of behavioral finance have shown that investors' irrational behavior tends to be systematic. The point here is that illusions must be identified early and counteracted in an appropriate manner.

The efficient-market theory

The efficient-market theory states that security prices efficiently incorporate all public information. Supporters of the efficient-market theory contend that if information about a particular security is publicly available to one investor, then it is available to all investors. Consequently, the price of a security reflects its true investment value at all times.

Asset allocation relies on the fact that markets are efficient and that investors behave in rational, predictable ways. Investors do not always behave rationally, however and, rational behavior is not as widespread as one may believe. In fact, investors actually can end up being their own worst enemies. Investment decisions are influenced by several emotional and psychological factors, and this fact has given rise to the field of behavioral finance.

Investor irrationality

Figure 2 When an investor suffers from short-term focus, he or she inappropriately focuses on short-term risk as opposed to long-term risk.

Consider all of the complex financial decisions faced by investors today. Without experience in different market environments or knowledge of market history, how might many of these investors make their financial decisions? Potentially through their perceptions or based on their emotions. For this reason, it is imperative that investors understand and combat the myriad of illusions they may be prone to.

Overconfidence

When an investor suffers from overconfidence, he or she rates himself or herself as above average when making investment decisions. Being overconfident often leads to overestimating the probability of good outcomes. Overconfidence can cause people to focus primarily on the upside of investments while underestimating the probability of poor outcomes for events over which they have no control.

In "Behaving Badly," a 2006 study conducted by Dresdner Kleinwort Wasserstein Securities Limited, 300 professional fund managers were presented with several questions, and one related to overconfidence. In an attempt to see just how over-optimistic fund managers were, they were asked: "Are you above average at your job?" Some 74% of the sample reported themselves to be above average at their jobs. Many wrote comments along the lines of "I know everyone says they are, but I really am!" Of the remaining 26%, most thought they were average, but very few, if any, said they were below average.