`Individual investors are dumb money'

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D. Murali

BRACE UP, this line may hit you like a tonne of bricks: "Individual investors have a striking ability to do the wrong thing." And, before you recover from the shock, here's more: "Individual investors are dumb money... Individuals hurt themselves by their decisions... By doing the opposite of individuals, one can construct a portfolio with high returns."

Hey, who's saying all this, you ask in disbelief. It's Andrea Frazzini of the University of Chicago, and Owen A. Lamont of Yale School of Management, in a recent research paper titled Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns, posted on the site of National Bureau of Economic Research (

You may discount the comment with a quote of Mark Twain, that it is all man's vanity and impertinence to call an animal dumb because it is dumb to his dull perceptions. But if you wade through the 60-page paper, you would learn that the authors' interest lies in that tearjerker word, `sentiment', and in how it rubs on to returns.

Sentimentality is the only sentiment that rubs you the wrong way, cautions Somerset Maugham, and I'm afraid it applies to stocks too, because the paper hypothesises that if sentiment pushes stock prices above fundamental value, high sentiment stocks should have low future returns.

"Individual retail investors actively reallocate their money across different mutual funds," writes the pair, noticing that the money mix between funds changes by billions of dollars, even as investors "transfer money from funds with low recent returns to funds with high recent returns."

It is common knowledge that investors are also driven by sentiment and the past returns of the mutual funds. The authors test if sentiment affects stock prices; more specifically, they study "whether one can predict future stock returns using a flow-based measure of sentiment."

An example in the study is that of Janus funds that attracted $37 billion in 1999, even as only $16 billion went to Fidelity funds, though the latter had "three times the assets under management at the beginning of the year". In 2001, the position reversed; "investors had changed their minds about their allocations, and pulled about $12 billion out of Janus while adding $31 billion to Fidelity."

Sadly, though, the reallocation caused wealth destruction to mutual fund investors as Janus and tech stocks performed horribly after 1999, the authors narrate. "Mutual fund investors are dumb in the sense that their reallocations reduce their wealth on average," aver the authors, and call this predictability the `dumb money' effect, something that poses a challenge to rational theories of fund flows!

Well, there can be two views on whether the tech bust happened because of the emotional baggage, but you may be happy to know that some researchers think of investors as smart guys and gals. For instance, there is the `smart money' hypothesis of Gruber (1996) and Zheng (1999), one learns; according to this, "some fund managers have skill and some individual investors can detect that skill, and send their money to skilled managers."

Lucius Annaeus Seneca said, "When I think over what I have said, I envy dumb people." But you may envy the smarter ones when reading Frazzini and Lamont to know that the dumb money effect is related to the value effect. "Money flows into mutual funds that own growth stocks, and flows out of mutual funds that own value stocks," they note.

And something more serious too happens: Demand begets supply. "When individuals indirectly buy more stock of a specific company through mutual funds, we also observe that company increasing the number of shares outstanding for example, through seasoned equity offerings, stock-financed mergers, and other issuance mechanisms," is a snatch from the paper, that lends credence to the view that when individual investors act dumb, smart firms opportunistically exploit their demand for shares.

"If someone's dumb enough to offer me a million dollars to make a picture, I'm certainly not dumb enough to turn it down," is a quote of Elizabeth Taylor that can perhaps explain the situation of firms eagerly lapping up investor appetite. Contrary to a popular myth, it is not financial institutions that exploit the individuals, according to the study. Rather, such blame may lie on the non-financial institutions that issue stock and repurchase stock.

Frazzini and Lamont consider other researches in this terrain such as of Wermers (2004) and Coval and Stafford (2005), that mutual fund inflows actually push prices higher; and of Sapp and Tiwari (2004), that by chasing past returns, investors are stumbling into a valuable momentum strategy.

"Whatever the explanation, it is clear that the higher returns earned at the short horizon are not effectively captured by individual investors," opines the paper on hand, painting a bleak picture of lost value. "It could be that some subset of individuals benefit from trading, but looking at the aggregate holdings of mutual funds by all individuals, we show that individuals as a whole are hurt in the long run by their reallocations."

Aggregate mutual fund investor could raise his Sharpe ratio by 9 per cent simply by refraining from destructive behaviour, assures the paper. For starters, the ratio in question is a direct measure of reward-to-risk, as explains.

Unfortunately, as individuals ultimately control fund managers, it can be difficult to infer the views of fund managers by looking only at their holdings, say the authors quite resignedly. "For example, when the manager of a tech fund experiences large inflows, his job is to buy more technology stocks, even if he thinks the tech sector is overvalued... It is hard for a fund manager to be smarter than his clients." A case of tail wagging the head, it seems.

The authors find `some modest evidence' of fund managers possessing stock-picking skill. If that's good news, what's bad is that whatever skill the managers have "is swamped by other effects including the actions of retail investors in switching their money across funds."

In the final analysis of Frazzini and Lamont, financial institutions appear only as "passive intermediaries who facilitate trade between the dumb money, individuals, and the smart money, firms."

To lift your sagging spirits, though, here is an Erica Jong quote, that I'd wrap with: "You see a lot of smart guys with dumb women, but you hardly ever see a smart woman with a dumb guy." May be, you can replace `women' with `money' in that line, to explain why you money isn't as smart as you'd like it to be.

(This article was published in the Business Line print edition dated August 21, 2005)
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