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The relative performance of no-load, growth-oriented mutual funds persists in the near term, with the strongest evidence for a one-year evaluation horizon. Portfolios of recent poor performers do significantly worse than standard benchmarks; those of recent top performers do better, though not significantly so. The difference in risk-adjusted performance between the top and bottom octile portfolios is six to eight percent per year. These results are not attributable to known anomalies or survivorship bias. Investigations with a different (previously used) data set and with some post-1988 data confirm the finding of persistence.ACADEMIC STUDIES SINCE THE 1960s find that mutual funds do not systematically outperform benchmark portfolios (such as the "market" indices)-see the classic papers by Treynor (1965), Sharpe (1966), and Jensen (1968, and recent updates with refinements by Grinblatt and Titman (1989b), Connor and Korajczyk (1991), and references therein. The practitioner literature sees matters differently, expressing a consistent belief that active selection among actively managed funds can be profitable. For instance, Rugg (1986) advocates, with some caveats, investing in aggressive-growth equity funds that are top-ranking performers in the most recent phase (one to six months) of a bull market. Similarly, Consumer Guide (1988, p. 14) reports, "Loads, fees, and expenses can be considerable, but most financial professionals suggest that the performance of the fund, not the costs, should be the primary consideration when choosing a fund."Mutual fund performance rankings are compiled on a regular and timely basis and are widely followed. Mutual funds that do relatively well tout their performance prominently in their advertising. Those that do not, search for

The net returns of no-load mutual gro'Mh funds exhibit a hot-hands phenomenon during 1974-87. When performance is measured byJensen's alpha, mutual funds that perform well in a one year evaluation period continue to generate superior performance in the following year. Underperformers also display short-run persistence. Hot hands persists in 1988 and 1989.The success of the hot hands strategy does not derive from selecting superior funds over the sample period.The timingcomponent -knowing when to pick which fund -is sigeificant. These results are robust to alternative equity portfolio benchmarks, such as those that account for firm-size effects and mean reversion in returns.Capiti'ing on the hot hands phenomenon, an investor could have generated a significant, risk-adjusted excess return of 10% per year.

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Are financial markets efficient? Do their participants behave rationally? Does a positive answer to the second question imply a positive answer to the first? And vice versa? These remain open questions despite decades of effort by economists and numerous claims that the issues have been resolved. Financial markets are extremely competitive (with near-instantaneous price adjustments and little room for strategic behavior), with virtually no externalities from participants' actions. Under such conditions, individual rationality can aggregate to collectively efficient outcomes. A body of work developing this view was honored by the Nobel Committee in Economics when it awarded its 1990 prize to modem finance's pioneers, Harry Markowitz, Merton Miller, and William Sharpe. But does this paradigm capture most financial market behavior? Clearly, some of the participants in financial markets do not act with perfect rationality; that is, they make mistakes.' But more astute players stand ready to capitalize on their mistakes-for example, to buy when panic leads to speculative market crashes, to extract I /8s and l/4s from individuals who trade in and out in the mistaken belief that they can beat the market, or to take positions to bring mispriced stocks into line. Given this sort of "poaching" (which includes arbitrage), the collective outcome may be indistinguishable from the one that would result if all participants behaved with perfect rationality. Consequently, one might expect to find few instances of nonrational financial behavior at aggregate levels. But then how can we account for speculative fads, from the Dutch tulip mania of the seventeenth century to the rash of junk bonds in the 1980s (see Shiller, l989)?2 Equally puzzling is the crash of October 1987, which reduced the stock market's value by onethird, although no significant bad news had broken. Such events hint that the rationality paradigm may not be universally applicable, but since each case is unique in important respects, their true cumulative significance is difficult to interpret. Academic attempts to identify inefficient aggregate behavior, or to refute the assumption of a rational representative agent, have focused predominantly on asset prices. Shiller' s (1981, 1For our purposes, a nonrational or irrational agent is simply one who differs from the neoclassical homo economicus prototype characterized by Von Neumann-Morgenstern utility, optimal expectatIons. Bayesian updating rules for probability revision, and so on. The qualifier behavioral.' in our paper, is interchangeable with "nonrational,' and carries no pejorative connotations. 2Bad overall outcomes can result from good individual choices as well as from poor ones. In this spirit, the economist explains various undesirable social phenomena, from unemployment to traffic congestion. a,s collectively suboptimal outcomes that result 1mm rational individual choices (Sehelling, 1978).

The insights of descriptive decision theorists and psychologists, we believe, have much to contribute to our understanding of financial market macrophenomena. We propose an analytic agenda that distinguishes those individual idiosyncrasies that prove consequential at the macro-level from those that are neutralized by market processes such as poaching. We discuss five behavioral traits -barn-door closing, expert/reliance effects, status quo bias, framing, and herding-that we employ in explaining financial flows. Patterns in flows to mutual funds, to new equities, across national boundaries, as well as movements in debt-equity ratios are shown to be consistent with deviations from rationality.

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