Finance: Behavioral Economics in Mutual Fund Investing

Behavioral Economics in Mutual Fund InvestingNameInstitutional AffiliationCourseDate
The authors of the article, Behavioral Biases of Mutual Fund Investors, Bailey, Kumar and Ng (2011) carry out an examination on the influence of behavioral biases on mutual fund investing using a large sample selected from US brokerage investorsCITATION Bai11 \p 1 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 1). The authors point out that in most cases, behavioral biased investors end up making wrong choices on the ways of funding, the trading frequency and timing leading to poor performance of their investments. Previous studies on the topic evaluate behavioral biases in relation to the investment of the individual stocks and little studies have been carried out to evaluate behavioral biases on mutual fund investment. Most of the individual investors prefer using the mutual funds to invest in the equity market as compared to trading them. Research carried out show that there is a reduction on the individual investment in the stock trading activities. According to the authors, the mutual fund investment decisions have an influence on the stocks indirectlyCITATION Bai11 \p 2 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 2). Most of the individual investors also prefer buying the mutual funds that have higher fees showing that most of these individual investors are members of the higher fees mutual funds companies. It has also been observed that most of these individual investors prefer chasing higher returns and thus they will select funds that have past evidence of higher returns. Previous research carried out show that most of the individual investors prefer the above options due to behavioral-biases. Chasing returns has been defined as an agency problem that makes most of the fund managers to adjust the risk of the investment and maximize the flow from the investment options instead of using the risk adjusted investment returns.
Based on a research carried out by the three authors, the decision making biases of investors are linked to their history of mutual fund investing. Data records from many US individual investors have been examined in the experiment. Individual behavioral biases of investors are also linked to mutual fund holding and their trading that give an overall picture of the behavior of the individual investors. Behavioral factors such as the disposition effect where on sells winners quickly and holds losers for long can make some of the investors to overestimate the expected returns and chose high-front end fundsCITATION Bai11 \p 4 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 4). Narrow framing biases were an investors buys and sells without considering the effects on the total portfolio and overconfidence characterized by frequent trading even if there is a poor performance are also behavioral biases of the individual fund investors. Others can prefer to choose the speculative stocks that allow them to switch quickly across a large number of asset classes without considering the higher feesCITATION Bai11 \p 4 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 4). Local bias can also make investors to choose the locally managed funds without taking a consideration of their cost and their expected performance. Some investors see the stocks and the mutual funds investment options as layers meaning that they have their perception about each of these options. If they tend to think that the mutual funds are safer than the individual stocks, the investors will spend less of their time to carry out an assessment on the cost and the performance of the fund. Despite the different behavioral bias of the investors, common characteristics such as poor decision on timing, the holding periods and the choice of funds can lead to poor performance.
Findings show that most of the behavioral-biased investors appear to stick to particular type of funds and trade on them frequently even though they have poor performanceCITATION Bai11 \p 6 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 6). Most of the fund industry investors also come up with fud offerings designed to attract and exploit such investors. The sophisticated investors on the other side who are well-informed, older and are more experienced carry out their investments in the mutual funds in the most appropriate manner. They can hold high proportion funds for a long period of time while avoiding the high expense funds. All these characteristics contribute to good performance of their investments. Behavioral biased investors do not pay attention to macro-economic news and therefore they do not hold the mutual funds for long and are more likely to select mutual funds with bad returns. They are also more likely to chase the performance of the fund since they are not aware that trend chasing can affect their rational investment decisions.
Behavioral Theories Utilized
The researchers have utilized mental accounting in behavioral economics to carry out the research. Mental accounting was founded by economist Richard Taylor. The concept behind this theory is that people think of value in relation to relative terms other than the absolute terms. Mental accounting can lead to good or bad financial decisions. In most cases, it can lead to bad financial and investment decisions CITATION Tha04 \l 1033 (Thaler & Benartzi, 2004). Mental accounting should actually not be existing since money should actually be viewed as fungible meaning that cash at hand and the money in the bank account have the same value and utility CITATION Tha90 \l 1033 (Thaler R. H., 1990).
The authors carry out an evaluation of two mental dispositions that is disposition effect and the narrow framing. Disposition effect is where an investor sells the winners too early and holds the losers for long. The disposition effect is usually related to the tax incentives that are offered. For instance, for the high income individual investors, retaining the losers can be costly for themCITATION Bai11 \p 4 \l 1033 (Bailey, Kumar, & Ng, 2011, p. 4). However, realizing the losses during December instead of the other months of the year is viewed as a tax minimization strategy. The na...