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Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds

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  • James J. Choi
  • David Laibson
  • Brigitte C. Madrian

Abstract

Experimental subjects allocate $10,000 across four S&P 500 index funds. Subject rewards depend on the chosen portfolio’s subsequent return. Because the investments are not actually intermediated by the fund companies, portfolio returns are unbundled from non-portfolio services. The optimal portfolio therefore invests 100% in the lowest-cost fund. Nonetheless, subjects overwhelmingly fail to minimize fees. When we make fees transparent and salient, portfolios shift towards cheaper funds, but fees are still not minimized. Instead, subjects place high weight on normatively irrelevant historical returns. Subjects who choose high-cost index funds are relatively much less confident about their asset allocation choices.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12261.

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Date of creation: May 2006
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Publication status: published as Choi, James J., David Laibson, and Brigitte C. Madrian. “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds." Review of Financial Studies 23, 4 (April 2010): 1405-1432.
Handle: RePEc:nbr:nberwo:12261

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