That sinking feeling

This high underperformance cannot be attributed to mutual fund fees but to the fact that investors do not consistently invest in mutual funds but move in and out. Mutual fund flows have been researched many times finding that “investors chase past period returns”, that is, funds flow into mutual funds when they gained and they are withdrawn when the fund lost.

In our recent white paper by the Deutsche Asset & Wealth Management Global Financial Institute, we presented international evidence demonstrating that behavioural finance (specifically, loss aversion and impatience) is very important in understanding how mutual fund flows relate to returns. In particular, in those countries with a high level of loss aversion, investors are more prone to sell mutual funds when they incur losses and more prone to buy when they experience gains. Moreover, in countries with a high level of loss aversion and a high degree of impatience, we find higher volatility of flows, which hints at impulsive trading in and out of mutual funds.

While traditional finance is based on the hypothesis that investors are totally rational, behavioural finance has amassed evidence that real investors are prone to behavioural biases. By now, there are many surveys on behavioural biases that are important to mutual fund flows and those biases can be explained using a roller coaster analogy.

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Figure 1: A typical behavioural investor on the roller coaster.

This analogy clearly illustrates the importance of a consistent investment strategy. Had the investor remained invested throughout the whole cycle, he could have gained a higher return. But since the downturn was too severe for the investor, he jumped out of the boat when the sea was rough. An investor who could bear the short-term losses, staying focused on his long-term investment goals mostly ends up with a better performance in the long term.

Two factors are decisive in gaining an excess return: patience and loss tolerance. Supposing that this result describes the typical investor’s behaviour, we should expect that the wealth flows are determined by a combination of the funds’ returns and the degree of patience and loss aversion of the average investor. We should expect that cross-country differences in fund flows can be explained further by differences in average loss aversion and patience across countries. Moreover, particularly fund flows’ sensitivity to financial returns could be also related to behavioural factors such as loss aversion and impatience.

The above charts compare – across the international test on risk attitudes countries – the degree of patience (measured as the percentage of respondents willing to wait for one month to get a 10 per cent return) and the degree of loss aversion (measured by the ratio of the gain that the respondent would require to invest in a fair lottery when the potential loss is 100).

Figure 2 shows that Russia, Chile and more southern countries are the least patient countries while countries in northern Europe and those close to Germany are the most patient, according the this measure.

Figure 3 proves that the Anglo-Saxon countries are the least loss-averse while some Eastern European and Asian countries are quite loss-averse.