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Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions,☆☆,,★★,☆☆☆

https://doi.org/10.1006/obhd.1999.2835Get rights and content

Abstract

This study examines the portfolio allocation decisions of 80 business students in a computer-based investing simulation. Our goal was to better understand why investors spend so much time and money on actively managed mutual funds despite the fact that the vast majority of these funds are outperformed by pas sively managed index funds. Participants' judgments and decisions provided evidence for a number of biases. First, most participants consistently overestimated both the future perfor mance and the past performance of their investments. Second, participants overestimated the intertemporal consistency of portfolio performance. Third, participants were more likely to shift their portfolio allocation following poorer performance than following better performance, and this tendency had a negative impact on portfolio returns. We speculate that these biases in investor behavior may contribute to suboptimal investment decisions in real financial markets.

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  • Cited by (0)

    The authors appreciate the generous support of the Dispute Resolution Research Center at Northwestern University. Portions of this paper were written while the first two authors were visiting at Harvard Business School.

    ☆☆

    There was a second manipulation that modified the way in which participants received information about their investments. In the nominal feedback condition, participants saw all returns in nominal percentages. In the market feedback condition, participants saw all returns in market-adjusted terms. However, this manipulation had no effect on the dependent variables of interest, and so it has been emitted from the present analysis.

    Every fund charges management fees to its investors, and these fees are calculated as a percentage of one's investment. These fees come in the form of expense ratios (which are charged annually) and front loads (which are charged once for each new deposit).

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    Recall that participants were provided with information after each round concerning the performance of their investments and the performance of the S'P 500.

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    These two outliers switched dramatically more than other participants. They each switched over 45% of their assets on the average return, which is four standard deviations above the mean.

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    Address correspondence and reprint requests to Don Moore, Department of Organization Behavior, Kellogg Graduate School of Management, 2001 Sheridan Road, Evanston, IL 60208. E-mail: [email protected].

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