The funds management industry is built on the premise that investors are better off entrusting their investments to experts who take a disciplined analytical approach to deciding which stocks to buy or sell. Individual investors, the thinking goes, are too governed by emotions like greed and fear to make intelligent investment decisions. But are fund managers just as prone to poor decision-making as do-it-yourselfers?
Behavioural finance analyst, Frank Ashe, a professor at Macquarie University’s Applied Finance Centre, says that investors generally think they are cleverer than they really are – and fund managers are no exception. “Investors tend to be over-confident and over optimistic,” he says, “and when things go well they assume it is because of their own actions.” When things don’t go according to plans, investors tend to gloss over their role in the underperformance, blaming factors that are beyond their control.
Experts are just as likely as individual investors to credit themselves when things go well and to rationalise poor results, Ashe says. “When things go wrong, experts tend to look for other factors that explain why things didn’t go as expected instead of accepting that their system may be wrong,” Ashe says. “They, like individual investors, will happily rewrite history to suit their needs and show they were in control.”
The fact that fund managers spend their entire day sifting through information to guide them in their decision-making doesn’t necessarily help make them better decisions, either, says Ashe. In fact it can be a problem, he suggests. “Extra information tends to increase your confidence, thus increasing the risk of your portfolio.”
This over-confidence, some would say arrogance, can also undermine fund managers’ ability to make good selling decisions, according to asset management consultant Inalytics, which examines the behavioural factors that potentially damage or improve investment performance. Managing director Amanda Field says that fund managers, by nature, are optimists. “They’re always looking for the next best position,” she says. The trouble is that they’re less interested in the stocks they already hold and tend to be vulnerable to what’s known in behavioural finance as the “disposition effect – the tendency to sell winning stocks too early and hold on to loss-makers too long.
The disposition effect is most usually associated with individual investors and their tendency to hang on to losers because they dislike incurring losses even more than they enjoy making gains. But fund managers are just as likely to suffer from the same malady, says Field.
To be a good stock seller you need to have an element of cynicism – a rare quality in a fund manager, Field says. “Good sellers tend to be cynical, pessimistic and always looking for the hidden problem lurking around the next corner.” They also have to be prepared to admit their mistake in buying the stock in the first place, something that may be commercially difficult for fund managers to concede to their unitholders.
This is borne out by research conducted by Harvard Business School in 2004 that shows that when a fund has a changeover in management, the new management tends to have a spring clean, selling en masse the losers they have inherited. Which perhaps argues the case that the time to buy into a managed fund is just after a management changeover. Or perhaps not at all.
One good argument for buying into a managed fund is to diversify a limited amount of money across a range of stocks. But unless you can be confident that a fund manager is going to be no less prone to poor investment decisions than you as an individual investor, you may well be better off buying an index fund or an ETF (exchange traded fund). It will achieve the same end, and a lot more cheaply.