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?

Rational minds can act irrationally

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

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.