Let the Good Times Roll: Subjective Expectations and Asset Management

Using a unique regulation implemented in a developing financial market—the mandatory disclosure of macroeconomic and security-market outlooks required of all Chinese mutual funds—we construct direct measures of portfolio managers’ subjective expectations and their influence on asset allocation decisions. Despite their sophisticated skills, high-powered incentives, and access to extensive information, fund managers’ subjective expectations are highly heterogeneous and deviate significantly from rational expectations. Managers extrapolate from their recent performance when forming beliefs about aggregate market conditions, but this extrapolation is asymmetric—occurring only when they outperform. The extrapolation is more pronounced among inexperienced managers and those who maintained an optimistic outlook in the prior year. Self-confirmation bias is consistent with the asymmetric extrapolation of recent positive performance to aggregate expectations, which disappears when new managers assume control, is muted in fund managerial teams that include women, and is more pronounced for fund managers that subjectively evaluate their recent performance as strong. Fund managers act on their biased beliefs by taking on higher-than-optimal risk when forming excessively optimistic aggregate expectations, which leads to suboptimal fund performance and can hurts millions of passive investors.