Why Not Lose Those Mutual Fund Losers?

Lagging funds tend to keep bringing up the rear. Why is it, then, that investors are more likely to sell their winners?

As an investor, I'd love to see myself as Mr. Spock--supremely rational, making each portfolio move with a Vulcan's cool precision. The honest record shows something else. Even if I can figure out which mutual funds to buy, for example, I'm always nagged by doubts about whether--and when--to sell.

There's small solace in it, but fresh research into investor behavior shows I've got plenty of company. In a paper that is now making the rounds of academic conferences, a trio of finance professors report that investors are doing a poor job of managing their fund portfolios. What's especially striking: When investors choose to sell, they are more than 2 1/2 times as likely to dump a winning fund than a loser.

Such "loss aversion," as this behavior is called, has been found repeatedly among people investing in stocks, options, futures, even in homes. It's a basic human bias, one Spock just wouldn't get. "You feel a lot better about selling a stock that has doubled than you do selling a loser," one of the researchers, Brad Barber of the University of California at Davis, told me. It may feel better, but selling winners over losers often doesn't compute for tax reasons alone: It can force you to pay capital-gains tax, while dumping a loser can shelter other income.

SUSPICIONS. Just the same, Barber and his co-authors, Terrance Odean of U.C. Davis and Lu Zheng of the University of Michigan, had good reason to wonder whether mutual-fund investors would follow suit. For one thing, fund holders have the opportunity to blame bad performance on portfolio managers instead of on themselves. And because they can "fire" poor managers by selling the fund, the researchers suspected fund investors might be less shy about recognizing losses. Also, it has often been shown that most laggard mutual funds keep right on lagging--another reason to suspect that fund investors might be quicker to dump losers.

To examine this, the professors analyzed fund-trading records of more than 32,000 households. The records--without owners' names--came from an unnamed discount brokerage firm. In all, they looked at 312,323 trades in diversified U.S. equity funds over the six years that ended in December, 1996. They weren't shocked to find that investors chased past fund performance: Funds with returns good enough to place them in the top 20% of the past year's rankings drew more than 54% of the buys. In other words, investors overwhelmingly bet that past performance would persist.

But investors bet the other way when it came time to sell. Then, 38% of the funds they sold were also in the top 20%. Just 14% were in the worst-performing quintile. With buyers and sellers both targeting the best-performing funds, Barber said, "it's tough to make the case that they're being very selective."

Nor were these investors intelligently choosy when it came to some mutual- fund fees. While they did shy away from funds that charge obvious loads or brokerage commissions, they paid no apparent attention to a fund's operating expense ratio, a more hidden cost. In fact, they actually preferred funds with higher annual costs, which other research has shown to be a losing strategy. Investors might do better, the professors suggested, if funds told them more plainly their actual costs in dollars. But as it is now, Odean noted, "funds have no reason to compete on price."

If there's a bright spot in all this, investors who call their own shots might find it in parallel research Zheng is pursuing. She wonders whether various classes of institutional investors, such as financial advisers, manage mutual-fund portfolios any better than do-it-yourselfers. Her early finding is no: "None of them are selling the losers."

Whether or not you use an adviser, how can these findings help you? First, remember to buy low-cost funds. Then, if you need to raise cash by selling one of them, put on your Spock ears and cut off a loser.

Questions? Comments? Send an e-mail to barkerportfolio@businessweek.com or fax (321) 728-1711

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