Professional investor psychology and investment performance: evidence from mutual funds
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In the seven decades following the Investment Company Act of 1940 coming into force in the United States, the mutual fund industry has undergone dramatic changes including, some argue, a transition from stewardship to salesmanship with asset-gathering becoming the industry’s driving force. As fund managers incrementally assumed a more pronounced role in the investment fund industry, an emerging strand of finance literature focused on their characteristics and their potential impact on investment performance. While a large body of academic research concurs that fund managers cannot outperform systematically better than chance, there are also a significant number of studies that link the psychological characteristics of investors to their investment performance. Importantly, we know that fund managers, as a representative sample of professional investors, often have to operate under enormous anxiety and associated psychic pressures. In their effort to cope with these pressures and make sense of an immensely unpredictable and complex work environment, a wide range of psychic defences and behavioural biases may be triggered. The purpose of this research is to investigate, on the one hand, to what extent mutual fund managers are prone to overconfidence and associated behavioural biases such as self-serving attribution. On the other hand, the extent to which overconfidence, proxied by a wide range of variables including overoptimism, excessive certainty and excessive self-reference, may have any bearing on fund performance is of interest. The fundamental question is why, how, and through which mechanisms does overconfidence affect performance. The underlying research questions are motivated by three large areas of research: studies of mutual fund performance and persistence, studies of financial accounting narratives, and studies of professional investor psychology. I also explore how overconfidence is fundamentally generated and, in a sense, resorted to by fund managers as a defence mechanism against the psychic pressures of having to work in a highly intangible, complex and uncertain environment. Drawing on evidence from fund manager reports written for investors, I explain how they use the medium of narratives, and in particular stories, to make sense of what they do as fund managers and their added value for clients. I demonstrate how analysing fund manager commentaries, both through computer-assisted corpus-linguistic approaches and through the “close reading” method, sheds light on the link between fund manager psychology and investment performance. In particular, from the perspective of narrative analysis, I explain how fund managers write their reports in distinguishably different genres depending, among others, on their past performance record, fund size and investment style. In addition, I establish in a longitudinal study that the overall economic environment in which fund managers operate does influence the rhetoric of fund manager reports as well as the evidence for the Pollyanna hypothesis. My findings also suggest that excessive overconfidence is associated, to a large extent, with diminished future investment returns. While superior past returns are expected to increase fund manager confidence which, in turn, may introduce the overconfidence bias in the investment decision-making process and thus diminish returns (through inefficient stock selection, suboptimal market timing and other possible mechanisms), this is not a simple regression towards the mean. The asset pricing model employed in my empirical analysis, the Carhart four-factor model, controls for the effect of previous-year momentum, and my overconfidence measures are only slightly correlated with the momentum figures. Hence, one is led to the conclusion that the narrative-based variables used in this study indeed capture some aspect of the professional investor psychology, and are capable of enhancing the explanatory power of conventional asset-pricing models such as Carhart’s. In investigating the dynamic relationship between fund manager overconfidence and investment performance, the cross-sectional variations in my study demonstrate that superior past performance boosts overconfidence as measured by all proxies employed. In addition, there appears to be an inverted-U relationship between overconfidence and subsequent investment performance. In particular, a hedging strategy based on shorting funds with extremely overconfident managers and going long in funds with normally (over)confident managers, yields positive average returns. The impact of overconfidence on subsequent returns is robust across different investment styles, although it is stronger among growth-oriented funds. Incorporating average scores for fund manager overconfidence over longer periods yields similar results. In addition, fund manager duration appears to correlate with managerial overconfidence in the long term.