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A second-best case for funds

Tom Chang and David Solomon at the University of Southern California and Mark Westerfield at the University of Washington point out that investors behave very differently towards shares and actively managed funds. In individual shares, they are prone to the disposition effect: they hold onto losing stocks while selling winners. But in funds they do the opposite - they sell past losers and buy past winners.

This difference, they say, is because of the way investors respond to cognitive dissonance - the discomfort we feel when two of our beliefs are inconsistent with each other. When one of our stocks does badly, we feel this dissonance because our belief that we are good investors clashes with the fact that we've bought a dud. Our reaction to such dissonance, says Professor Chang, is to resort to "defence mechanisms and mental tricks". One such trick is to persuade ourselves that it is the market that is wrong, not us, and that the stock will bounce back: such a trick is, of course, not always wrong, which is what makes it so appealing. This causes us to hold onto losing shares.

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