Positive Illusions and Forecasting Errors in Mutual Fund Investment Decisions

This study examines the portfolio allocation decisions of 80 business students in a computer-based investing simulation. Our goal was to better understand why investors spend so much time and money on actively managed mutual funds despite the fact that the vast majority of these funds are outperformed by pas sively managed index funds. Participants' judgments and decisions provided evidence for a number of biases. First, most participants consistently overestimated both the future perfor mance and the past performance of their investments. Second, participants overestimated the intertemporal consistency of portfolio performance. Third, participants were more likely to shift their portfolio allocation following poorer performance than following better performance, and this tendency had a negative impact on portfolio returns. We speculate that these biases in investor behavior may contribute to suboptimal investment decisions in real financial markets.