“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).
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:
- Controlling for fund, stock and time fixed effects, they found that the probability of a stock being repurchased by a mutual fund is on average around 17% higher if it were previously sold for a gain rather than for a loss.
- The effect is less pronounced if the stock price increased after the sale of the stock, which may cause regret and a negative feeling that the stock was sold in the first place.
- Mutual fund managers are more likely to repurchase past winner stocks if their prices decreased after they were completely sold.
- Fund managers changing jobs, and now working at a different fund, still prefer to repurchase stocks that they sold for a gain at the fund they managed before.
- Consistent with previous literature on the negative impact of group thinking on fund performance, team-managed funds exhibit a stronger repurchasing bias (more heads are not better than one in this case). Previous literature has also shown that a substantial fraction of mutual funds managers are subject to the well-documented disposition effect, realizing gains more readily than losses.
- A stock’s likelihood of being repurchased does not increase even further the higher the gain from the previous sale, while its likelihood of being repurchased does decrease even further the higher the losses incurred when selling the stock before. The asymmetric impact of the magnitude of losses and gains on the repurchasing probability may be due to the well-documented behavior known as “loss aversion.”
- The positive emotion-driven behavior is associated with lower fund performance: repurchased winners underperform repurchased losers by around 5 percentage points per year after the repurchase. The Carhart four-factor (beta, size, value and momentum) alpha of the repurchased winner portfolio is more than 4 percentage points lower than that of the repurchased loser portfolio.
- Repurchased stocks’ prices increase between the time they have been sold and repurchased, and stock prices of repurchased winners increase even more than those of repurchased losers, suggesting mutual funds would have benefited from just holding these stocks, especially winner stocks that they repurchase later. These results suggest that repurchasing bias of mutual funds is not due to superior information about past winner stocks.
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.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.