Why Fund Ratings Could Be Misleading

These guides assume every investor feels the same way about losing money
Shlomo Benartzi and John Payne

How helpful are mutual-fund rankings from research firms such as Morningstar  and S&P Capital IQ? New evidence suggests that for many investors, the answer may be “not very.”

Fund guides such as Morningstar’s popular rating system of one to five stars appeal to fund buyers because they transform complicated data into an easy-to-understand metric: A five-star fund is superior to a four-star fund, which is superior to a three-star fund, and so on.

The problem is, most traditional ratings guides don’t take into account who is doing the shopping. They assume every investor feels the same way about losing money when, in fact, behavioral economists in recent years have discovered a surprising amount of variation in how people feel about losses. As a result, fund-grading systems have the potential to provide misleading guidance to those whose loss tolerance falls outside the norm—which some recent research shows could be as many as half of all investors.

To address this fundamental flaw and help people make smarter investment decisions, we have developed a system for measuring sensitivity to financial losses. Our calculator is free, and investors can use it to determine how much attention, if any, they should pay to ratings when evaluating funds. We also believe this tool, or one like it, eventually could be used by ratings providers to create customized fund rankings that take into account each individual’s feelings about money losses.

Coin-flip test

Much of the research into risky choices has focused on loss aversion, which refers to the fact that losses tend to hurt more than gains feel good. (See work by Daniel Kahneman and Amos Tversky on risky choice behavior.) The easiest way to demonstrate loss aversion is to ask people whether they would accept the following bet on a coin flip: If the coin lands on heads, you’ll win $200. If it lands on tails, you’ll lose $100. (This hypothetical was first introduced by Nobel Laureate Paul Samuelson.) Do you take the bet?

Most people reject the offer, even if the math strongly suggests they should say yes. For these people, the potential pain of losing $100 exceeds the pleasure of winning twice that amount.

That said, not everyone feels the same way about the coin flip. Although the average loss-aversion coefficient is just over two—meaning that losses hurt twice as much as gains feel good—recent research by Duke University Prof. John Payne and his colleagues found that about half of subjects significantly deviate from the population average. Some have significantly higher loss-magnifying coefficients, meaning they are even more sensitive to the possibility of losing money. And, some have coefficients approaching one, which means they treat losses as nearly identical to gains. They seek out bets that are much more balanced in terms of possible gains versus possible losses. (A fraction of the population, approximately one in 10, is gain seeking, which is the opposite of loss aversion.)

Here’s how feelings about losses might skew fund ratings for investors: Say you’re extremely loss-averse, with a coefficient around five. (You require a gain of $500 to make up for a potential $100 loss.) A highly rated fund might still feel too risky to you.

The same problem applies in the opposite direction. For investors who are less sensitive to losses, fund ratings might overemphasize the emotional toll of losses. Because these people aren’t bothered as much by losses, they might prefer funds with higher potential returns, even if it means more dramatic ups and downs. 

It’s subjective

It is possible to quickly identify an individual’s loss-aversion coefficient with our calculator. (In the future, we hope other scientific calculators that measure key aspects of risk tolerance, and loss aversion in particular, are developed and made available to the public.) If you have a loss-aversion coefficient around two, then a traditional fund-rating system will probably provide you with acceptable guidance. But if your coefficient is either close to one or above three, then ratings guides might lead you to consider funds that don’t fit your actual levels of loss tolerance. 

Once a person’s loss-aversion coefficient is known, it should be possible to personalize investment ratings, ensuring that the highest-rated funds match an investor’s actual preferences. Countless websites and apps, from Amazon.com to Netflix , deliver personalized content to users based on their Internet shopping and browsing histories, so the technology to do this clearly exists. Over time, such personalization could minimize decision-making mistakes triggered by loss aversion, helping people make smarter investment choices.

Morningstar and S&P Capital IQ say their ratings are risk-adjusted already, and at this time they have no plans to offer customized fund rankings. Morningstar believes “attitudes toward risk should contribute far more to asset allocation and portfolio construction than to fund choice,” says Jeffrey Ptak, head of manager research at the firm. Todd Rosenbluth, director of mutual-fund and ETF research at S&P Capital IQ, says his firm’s research tools incorporate risk considerations at both the fund and holdings level, which allows investors to more easily sort through the universe of highly ranked funds for the best fit.

Still, we would argue that because risk is a subjective feeling, with different people experiencing the trade-offs between gains and losses in different ways, any attempt to offer guidance based on an investment’s historic level of risk should reflect these individual preferences. Only then will every investor be able to identify the funds that best suit their own psychological reality.

The Wall Street Journal