Your Limbic System Can Hurt Your Investments

When I was at West Point, during our junior year we were able to get a very low interest rate loan called the "cow loan." While I should have realized that there is no such thing as "good debt" and not taken the deal, I guess, in hindsight, I did the second best thing possible, which was invest the loan proceeds into four different mutual funds.

I don't remember what the specific funds were, but I do have a pretty good recollection of how I chose them. I took a look at a glossy handout showing the recent returns of all of the fund families available from the provider--USAA--and picked the four that had the highest returns. When we graduated, the banks started demanding payments, and I paid off the loan in full having made a little money.

According to research by the University of Chicago's Andrea Frazzini and Yale's Owen Lamont, I was lucky. According to their paper, "Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns," individual mutual fund investors display what the authors call a "dumb money effect," meaning that funds where individuals' mutual fund investment money flows subsequently shows a decrease in returns over the long-term.

First, let's define what this "dumb money" is. It is individual mutual fund investors moving money from one actively managed mutual fund to another actively managed mutual fund outside of the normal bounds of rebalancing. In other words, individual mutual fund investors try to chase the hot hand, as, by and large, this money is going to funds that have beaten the market recently.

By how much does this "dumb money" underperform the market? Frazzini and Lamont calculate that dumb money does 9 percent worse than the market as a whole.

What is happening here? Aren't mutual fund managers in their positions because they know what they're doing and can beat the market? There are a couple of explanations of what happens once all of this dumb money flows in:

--The managers might not have been that good in the first place. Sometimes there are outliers in performance due more to luck than anything else. It can take decades to determine if a mutual fund manager is lucky rather than skillful.

--Fund managers were forced to put more money to work than they wanted. Let's say, for the sake of argument, that a given fund manager does display real skill. He is the manager of a sector fund which performed well in the previous year. Now, a bunch of dumb money flows into the fund, and the manager is required to put it to work. He's going to have to find even more valuable investing opportunities than he found in the past to satisfy all of those new shareholders, even though he may not think that there are as many good opportunities as there were in the previous year. Instead of buying only A grade stocks, like he could previously do, he now has to buy A and B grade investments, diluting the quality of the portfolio and reducing the returns.

--Costs and fees eat up returns. The research of Frazzini and Lamont show that costs and fees contributed to the negative returns of the actively managed funds compared to their low-cost index fund alternatives. A high-fee fund manager had to perform even better to escape the shackles that loads and other expenses put on him.

So why does the average mutual fund investor chase that performance in the first place? In part, it's because your limbic system is managing your mutual fund investment strategy. At first, investing in the high-performing manager seems rational. Look for the highest performing funds and send your money there. It's what everyone else is doing! However, there are some psychological biases working against you. Let's outline just a few:

Recency bias. Recency bias is a psychological tendency to look at recent performances and infer a longer-term trend from them. What happens is that we see recent performance and expect that, contrary to constant warnings that "past performance does not indicate future results," we still chase the hot hand.

Selection bias. Selection bias means that you choose the wrong sample set from which to base your judgment about the overall outcome. In this case, individual investors are looking at recent performance of "hot" managers rather than looking at the overall body of work. Furthermore, once he sees a statistic that it likes, your limbic system--more specifically, the left-brain interpreter--is going to come up with a narrative which aligns with the story that it wants to tell you.

You: Are you sure we want to invest in this fund? He might have made 20 percent last year, but he lost 38 percent the year before, 22 percent the year before that, and the fund is down 8 percent since it launched.

Your Limbic System: GIVE THE ROCK TO THE HOT HAND.

You: There's also a 5 percent load to get into this fund. Ouch!

Limbic System: DON'T COUNT FEES IN OVERALL RETURN. DUMB HUMAN!

The Dunning-Kruger Effect. I've previously covered how the Dunning-Kruger Effect keeps makes you think that you're better at something than you truly are and makes average people think that they're experts in something. In this case, average mutual fund investors can get overwhelmed with data from reams and reams of prospectuses. Armed with these prospectuses, they then use mental heuristics to filter out the data into something which helps them make decisions. What's the most commonly used heuristic? Last year's performance. Then, when that hot manager invariably underperforms, rather than accurately pinpointing the true cause, they think that because they're better than the average investor, it was just an aberration, so, the next year, repeat the same mistake again.

It's very tempting to look at recent returns from actively managed funds and to invest with those managers. I did it when I first started investing. I have no idea if I outperformed the market. At least I was fortunate enough to pay off the cow loan when it came due.

When it comes to investing, don't let your limbic system determine your investments for you. Don't fall for the same biases that the average mutual fund investor does; it can be bad for the health of your portfolio.

Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.