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Common Investment Mistakes 137
to higher brokerage costs that are subtracted from their returns. By definition, the aggregate
of active funds (in which managers choose stocks) is likely to match the market,
before fees are subtracted (Sharpe, 1991). In the end, high expenses significantly reduce
the returns of these actively managed funds.
Now consider the case of hedge funds, which exploded onto the investment scene
in recent years. The amount of money under management by hedge funds has grown
nearly 600 percent in eight years, from $240 billion in 1998 to about $1.4 trillion at the
end of 2006 (Wall Street Journal, 2007). Hedge funds provide wealthy individuals and
institutional investors an alternative to traditional investment vehicles. By restricting
who can invest in them, hedge funds avoid certain governmental regulations and disclosures,
thereby allowing their managers to maintain secrecy about their investment strategies.
This secrecy, coupled with stories of spectacular gains from certain hedge funds,
has built a mystique that has attracted substantial investment. Furthermore, the high
fees that hedge-fund managers charge have meant that managers tend to achieve extremely
high incomes, even by the impressive standards of the investment banking industry.
For instance, hedge-fund manager James Simons earned $1.7 billion in 2006.
This sort of compensation has meant that hedge funds can attract the best talent away
from investment banks. Has this talent translated into superior performance?
The evidence suggests not. Kat and Palaro (2006) examined the performance of
nearly 2,000 hedge funds and concluded that only 18 percent outperformed the relevant
market benchmarks. The problem? As with actively managed mutual funds, the
high fees attached to hedge funds detract from any returns they might achieve. It is
standard for hedge funds to charge their investors ‘‘two and twenty’’—an annual fee
equal to 2 percent of the total amount invested, in addition to 20 percent of any investment
gains (Cassidy, 2007). These fees are similar to those of the most expensive actively
managed mutual funds. In fact, hedge funds perform even worse than Kat and
Palaro’s (2006) performance data suggest, as they only examined existing hedge funds.
As with mutual funds, the losers go out of business and thus are not included in longterm
performance data. If the analysis included these ‘‘ghost’’ funds, performance
would look even worse (Malkiel & Saha, 2005).
No individual who buys an active mutual fund or invests in a hedge fund is seeking
an investment that will perform far worse than average. Yet lots of people buy and continue
to hold onto them long after receiving evidence of their failure. The cost of these
mistakes adds up to billions of dollars. Why do people make these mistakes? While the
answers can be found in the preceding chapters of this book, researchers have developed
these insights into a new field of inquiry: behavioral finance.
Essentially, behavioral finance is an application of what we know about common
judgment errors to the world of investment. In the 1980s and early 1990s, behavioral
decision research was applied most extensively to the area of negotiation (which we will
cover in Chapters 9 and 10). In recent years, the most active area for new insights has
been that of financial decisions. This research gives us a better understanding of an
important set of life decisions and also offers clear evidence that the decision errors
described in this book are broad in scope. Behavioral finance focuses on how biases
affect both individuals and markets. This chapter focuses on the former application;
Shleifer (2000) and Shefrin (2000) are good sources on the latter.