Stock market investments, such as mutual funds, play an important role in the financial portfolios of millions of Americans. Mihaylo Finance Associate Professor Ajay Bhootra discusses his studies of mutual fund performance and investor reaction to risk.
In today’s world of 401(k) retirement plans, health savings accounts and educational savings plans, many Americans strive for a diversified investment portfolio that will maximize the ups of financial markets and minimize the downturns. Mutual funds are among the most popular investment choices.
Mihaylo Finance Associate Professor Ajay Bhootra examined mutual fund performance in his 2015 study, “Mutual Fund Performance: Luck or Skill?” “The bulk of evidence points to a mediocre average performance for these funds. In fact, the evidence suggests that a majority of these funds are unable to outperform their passive benchmarks,” says Bhootra. “Yet it is puzzling that the actively managed fund industry has experienced significant growth over the years.”
Skill, Luck, and Risk-Seeking Behavior
Bhootra examines whether the mutual funds that do outperform the market do so because of skill or chance. “While we are not the first to study this question, our research employs a statistical approach that has not been previously applied in this context,” he says. “Our key finding is that a small number of actively managed equity mutual funds do exhibit superior performance that is attributable to manager skill. Our evidence offers a rational justification for the existence and growth of these funds. Personally, I believe most investors are still better off investing in low-cost index funds, as identifying skilled fund managers is challenging.”
In another 2015 study, “High Idiosyncratic Volatility and Low Returns: A Prospect Theory Explanation,” Bhootra examines investor behavior toward risk. While conventional wisdom implies that investors will pull out of a declining market, Bhootra notes that many people display risk-seeking behavior in the hopes of recovering their money. “If you bought a stock at $50 per share and it goes down to $10 per share, you might have the incentive to take on excessive risk in order to try to break even and recover your potential losses,” he says. “When investors are risk-seeking, the risk/return relationship reverses. Risky stocks are in high demand, so we would expect them to be priced higher today and earn lower returns in the future. This is exactly what we find.”
Automated Investment and “Robo-Advisors”
Looking to the future, Bhootra anticipates that the trends toward an increase in index investing and technology in finance will continue. “Investors have shown an increasing inclination toward low-cost index mutual funds and exchange traded funds,” he says.
“I also foresee that automated investment and portfolio management services, the so-called ‘robo-advisors’ such as Betterment and Wealthfront, will continue to gain ground. We will see that technology will be increasingly pervasive in every domain of finance, including retail and institutional investing.”
Bhootra joined Mihaylo College in 2008 upon the completion of his Ph.D. in finance from Virginia Tech. His research interest is behavioral finance, which utilizes finance and psychology to understand financial decisions and market outcomes. “My motivation stems from my belief that many puzzling return phenomena in the stock market are attributable to mispricing of securities that derives from investors’ behavioral biases,” he says. “Behavioral finance challenges the conventional assumption of investor rationality and studying it holds great promise in advancing our understanding of how markets work.”
Investment Tips: The Long Game
Advising business students on the best financial choices, Bhootra recommends sticking to a long-term plan regardless of market performance. “Saving and investing regularly and sticking to a sound investment plan during market ups and downs are the key to long-term financial success,” he says. “It may sound cliché, but unfortunately, it is not something that we see many people doing.”
He notes that stocks have historically done better than many other investments. “Stocks have been one of the best performing asset classes, especially over long time horizons,” he says. “It is important for students to realize they have time on their side.”
For more on Mihaylo’s finance programs, visit the Department of Finance online or at SGMH 5113.