Dumb Money In Mutual Funds

Dumb Money in Mutual Funds

It appears that individual investors have a marked talent for investing badly in mutual funds,

They have a preference for buying mutual funds that have been strong performers in the recent past. This is not entirely surprising; only the successful funds that are advertised, while less successful funds are left to flounder, unloved and starved of publicity.

Since much of the out-performance or under-performance of mutual funds is random, it's likely that this year's stellar performers will not hold their star positions for long. This year's stellar performers will, however, get a bigger share of investors' money than under-performing funds will. The flow of money into mutual funds which have performed outstandingly well in the recent past is dumb money.

Andrea Frazzini, of The University of Chicago, and Owen A. Lamont, of Yale, have found evidence that corporations are profiting by doing the opposite of dumb investors. The pair published a paper in 2006; Mutual fund flows and the cross-section of stock returns (pdf file).

Frazzini and Lamont found that when large amounts of money enter a mutual fund, the fund managers generally buy more of the stocks that make up the fund. This buying pressure can push the prices of these stocks up. The companies whose share price is rising issue more shares at elevated prices. Companies profit by issuing and selling shares for more than their true worth. Investors who buy into a stellar performing mutual fund lose money when the shares fall back to realistic prices.


Applying this Information Practically

The main lesson is that, if you buy into mutual funds which have performed very well in the recent past, your investment is likely to under-perform the market in the longer term. It makes sense not to buy into recently fashionable mutual funds.