Investment Behavior of Mutual Fund Shareholders

Investment behavior of mutual fund shareholders
Abstract:
The relationship of stock market returns with components of aggregate equity mutual
fund flows (new sales, redemptions, exchanges-in, and exchanges-out) is examined.
Vector autoregressions and tests of linear feedback show that the flow-return relationship
exists solely between returns and exchanges-in and -out. Further, only exchanges-out are
responsible for the contrarian flow behavior noted by Warther (1995). The evidence
suggests that the various components reflect different investor objectives and
information.
Introduction:
The Indian capital market has been increasing tremendously during last few years. With
the reforms of economy, reforms of industrial policy, reforms of public sector and
reforms of financial sector, the economy has been opened up and many
developments have been taking place in the Indian money market and capital
market. In order to help the small investors, mutual fund industry has come to
occupy an important place. While conventional academic finance emphasizes
theories such as modern portfolio theory and the efficient market hypothesis, the
emerging field of behavioral finance investigates the psychological and
sociological issues that impact the decision-making process of individuals,
groups, and organizations. This study will discuss some general principles of
behavioral finance including the following: herd behavior, communal
reinforcement, loss aversion, adaptive attitudes, financial cognitive dissonance,
the theory of regret, and prospect theory. In conclusion, the paper will provide
strategies to assist individuals (professionals) to resolve these "mental mistakes
and errors" by recommending some important investment strategies for those
who invest in stocks and mutual funds.
The journey from the October 2007 peak in the equity markets to the lows of March
2009 was an emotional rollercoaster for most investors. The journey was part of the
worst recession we have seen since the great depression and emotions were driving a lot
of investment decisions made over the past year and three quarters. Emotion tends to
reek havoc on long term investment results particularly when the emotion you feel
suddenly turns to panic and that is exactly what many investors did in the first quarter of
2009. We have seen study after study detailing how the average investor receives only a
fraction of long term index investment results due to poor decision making regarding
buying and selling of mutual funds. If you look at the data provided by the Investment
Company Institute’s weekly cash flows for 2009, you see a similar pattern that has played
out many times - investors selling equity funds at a particularly inopportune time as the
chart below shows you.
You can see from the sequence of inflows above that investors in equity mutual funds
sold billions of dollars of equities at the bottom of the market cycle in March. It is
extremely difficult to make up for that sort of headwind when looking at long term
results. In order to breakout the performance of the S&P 500 growth of a $1 return
pattern, please review the table below of monthly returns for the S&P 500:
In a few years when you review these results most people will fail to remember how the
first few months of 2009 actually played out. The S&P 500 was down 19.08% through
the first two months of this year and then proceeded to drop an additional 7.86% in the
first nine days of March bringing the total loss for the year to 26.94%. You will also fail
to remember that the S&P 500 was probably the best performing asset class both
domestically and internationally as most other asset classes were down much more. This
was in addition to the losses incurred in 2008 when the S&P 500 dropped 37%. The S&P
500 then proceeded to bounce back 18.04% from March 10th through the 31st finishing the
month up 8.76% and has been on an upward trend ever since. Fund flows did start to
bounce back in April and May but the question becomes, were the people who sold out at
the March lows part of the investors who were putting money to work again? I would
think that most people who sold out at the lows sat on the sidelines for a good amount of
time before putting any money to work again.
Dalbar Study
Dalbar recently concluded its 15th annual study of mutual fund investor behavior and the
study once again has found that the average investor receives a fraction of index based
returns due to buying and selling at inopportune times. To follow is a summary of the
reports findings:
• For the 20 years ended December 31st, 2008 the S&P 500 has returned 8.35% and
on the fixed income side, the Barclays Aggregate Index earned 7.43%.
Conversely, equity fund investors had average annual returns of 1.87% and fixed
income fund investors 0.77%.[1]
• The inflation rate averaged 2.89% over the same time period which means most
investors failed to keep up with inflation due to poor market timing decisions.
Summary:
Far too often the investor’s own behavior is the highest risk they face. Buying high and
selling low is not the way to make money in the capital markets. Market timing seldom
works, and the vast majority of people that attempt it do themselves great harm. Buy and
hold may require some courage at times, but, it’s the only time-tested, proven way to
reach your goals. Study after study has shown that the greatest detriment to long term
investment results is often the person making the investment decisions.
Chart Data provided by Investment Company Institute ©. Weekly cash flows are
estimates that are adjusted to represent industry tools, based on reporting covering 95%
of industry assets. Monthly flows are actual numbers as reported in ICIs “trends in
mutual fund investing”.

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