Investors are “Fooled by Randomness” and when chasing returns to make investment decisions in funds more often than not do not take into account key considerations that paint a true picture of the manager’s skill, says a study.

In the paper “Fooled by Randomness: Investor Perception of Fund Manager Skill,” the paper’s authors assert that the role luck plays in high return generation is not given proper weighting in investment evaluation nor is volatility given appropriate consideration.

Investment decisions

Fund Manager Skill: Investors overly subscribe to mutual funds

The study found that investors overly subscribe to mutual funds that underperform the market. “There is ample evidence that investors, once they have decided to invest into actively managed funds, buy the wrong funds. They chase returns and, by doing so, lose money on average.

Why do investors select the wrong mutual funds? The study says that first, investors “fail to derive information from the cross section.” In other words, they don’t assess the role luck plays in returns generation. They don’t understand that in a large cross section of fund returns, there must be a few strong performers by pure chance.

Second, investors fail to incorporate the fund volatility when determining the probability of manager skill. As a result, the study concludes, “gambling fund managers” will find it easier to attract investor money than more conservative managers. While investors are able to notice different levels of riskiness in time-series of returns, they are unable to draw conclusions about fund manager skill. Looking at past returns performance, the role of volatility in the creation this performance is an elusive concept to investors.

Investment decisions Fund Manager Skill

It’s not just that investors are not good at selecting the right funds, many also know it.

Fund Manager Skill: Investors cannot or can rather not identify skilled managers

The problem also seems to be one of confidence as well. Half the investors who participated in the study said they “cannot” or “can rather not” identify skilled managers, noted researchers Justus Heuer, Christoph Merkle, Martin Weber from the University of Mannheim in the United Kingdom.

The study evaluated various personality characteristics and demographics influence how people judge skilled and unskilled managers. Older study participants assume a higher share of skilled managers in the market than do younger investors. Men, on average, estimate the percentage of skilled managers to be lower than that of women. Higher educated study participants also were found to believe there are less skilled managers and more unskilled managers in the market than did less educated study participants.

Investment decisions

Investment decisions

 

The full study can be found here SSRN-id2493053