Positive illusions and forecasting errors in mutual fund investment decisions

This study examines the portfolio allocation decisions of 80 business stude nts in a computer-based investing simulation, Our goal was to better unders tand why investors spend so much time and money on actively managed mutual funds despite the fact that the vast majority of these funds are outperform ed by passively managed index funds. Participants' judgments and decisions provided evidence for a number of biases. First, most participants consiste ntly overestimated both the future performance and the past performance of their investments. Second, participants overestimated the intertemporal con sistency of portfolio performance. Third, participants were more likely to shift their portfolio allocation following poorer performance than followin g 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. (C) 1999 Aca demic Press.