The disposition effect – that is the propensity for investors to relinquish winning positions and maintain losing holdings – is one of the most prominent findings of behavioural finance, and has been widely studied and corroborated (for example – Frazzini 2006, Shefrin & Statman 1985, Weber & Camerer 1998). However, this description of investor behaviour often seems in sharp contrast to the activity of mutual fund investors, where the leaning appears towards the opposite – abandoning underperforming holdings and persisting with those delivering excess returns. A study by Chang, Solomon and Westerfield (2014), confirms this view and contends that fund investors evidence a reverse disposition effect. But why does fund investing provoke such a different behavioural response?
First, it is important to understand the existence of classic disposition theory. Although there are a range of competing explanations, the most compelling is that of cognitive dissonance (Festinger, 1962), which relates to our desire to find uniformity in our beliefs and values; avoiding situations where there are conflicts or inconsistency. If we make an investment that subsequently falls in value, or underperforms, we face the prospect of cognitive dissonance – we believe we are a skilful and diligent investor, yet the performance of the security jars with this view, creating a significant disconnect. Selling the position and crystallising a loss would only serve to confirm this contradiction, thus our tendency is to maintain the position and hold the opinion that we are right – just not quite yet.
Fund investors are not immune to cognitive dissonance, but they have an alternative means of relieving the stress caused by its occurrence – the ability to delegate accountability. Faced with the same dichotomy of believing in your own investment abilities, whilst witnessing a poorly performing investment choice, a resolution can be found by placing blame with the underlying fund manager and selling the investment.
This type of delegated investment authority has been referred to as a psychological call option (or indeed a protective put), which is a reasonable analogy – with a fund investment one can claim credit for the upside, whilst capping the (psychological) cost of disappointment. Outperformance is the result of superior fund selection, underperformance the consequence of problems with the fund manager.
Whilst this behaviour supports the desire for internal consistency, it also serves to protect our ego in the public domain. After diligently researching a fund and then stridently advocating it to your team / peers / clients; witnessing it struggle, even over brief and irrelevant time periods, can be emotionally taxing and perceived as damaging to your reputation. A decision to sell the fund is therefore far more easily rationalised by believing that things (out of your control) have changed, rather than acknowledging a mistake.
The inclination to sell losing funds is compounded by our bias towards outcomes and desire to construct coherent narratives. A proclivity to judge the quality of a decision or an activity by its results alone, leads us to identify problems with underperforming funds and become complacent about outperformers (despite performance alone providing minimal insight into the quality of an investment approach).
When a fund is underperforming, the urge to develop a persuasive story accounting for the returns is often overwhelming. Disappointing outcomes ‘must’ be related to some fragility in the investment approach, thus we seek to forge links between process issues (for example, capacity, team changes, style drift) and the performance delivered, even if the connections are erroneous. These patterns are exacerbated by the preference to expend more time studying struggling funds in order to understand and explain performance. Carrying out extensive research on a fund only to conclude that the underwhelming return is primarily due to random market noise, is unlikely to prove satisfying, even where accurate.
Confronted with an underperforming fund, an investor has three potential courses of action (this is a simplification):
i) Retain confidence in the holding as there has been no marked alteration to the philosophy and process, and the performance is consistent with expectations given the market backdrop. Maintain the fund.
ii) Acknowledge that although nothing material has changed, a mistake was made in the recommendation. Sell the fund.
iii) Identify a problem with the fund stemming from some kind of change or unwanted / unexpected development, which can be linked to performance. Sell the fund.
The first two options are by far the most behaviourally exacting. Maintaining confidence in a fund holding despite underperformance falls foul of our strong desire to link outcomes directly to process, and does nothing to relieve the aforementioned cognitive dissonance. Admitting an error serves only to crystallise the dissonance and tarnishes our ego. Contrastingly, the third option is behaviourally compelling. It enables us to relieve our dissonance by allocating responsibility elsewhere and sates our want to consistently align process and outcome. Given these features, the tendency of fund investors to sell losing positions is, perhaps, unsurprising.
This post is not designed to argue that we should blindly hold poorly performing funds, nor that there are never process problems or changes causing poor outcomes, rather it seeks to explain why the behaviour of fund investors appears to contradict the long established disposition effect. The decision making dynamics of fund selection differ markedly from individual securities, and lead to an apparent reversal of the phenomenon. This should not be viewed as either a positive or negative, simply a distinct behavioural challenge for investors in active funds to address.
Chang, T. Y., Solomon, D. H., & Westerfield, M. M. (2016). Looking for someone to blame: Delegation, cognitive dissonance, and the disposition effect. The Journal of Finance, 71(1), 267-302.
Festinger, L. (1962). A theory of cognitive dissonance (Vol. 2). Stanford University Press.
Frazzini, A. (2006). The disposition effect and underreaction to news. The Journal of Finance, 61(4), 2017-2046.
Shefrin, H., & Statman, M. (1985). The disposition to sell winners too early and ride losers too long: Theory and evidence. The Journal of finance, 40(3), 777-790.
Weber, M., & Camerer, C. F. (1998). The disposition effect in securities trading: An experimental analysis. Journal of Economic Behavior & Organization, 33(2), 167-184.