London: As the tennis season reaches its peak, investment managers should heed the lessons. There is ever greater understanding that our psychology and our basic tendency to use mental shortcuts can get in the way of good rational decision-making when investing. But how can we actually use this research in behavioural finance to improve the way we invest?
Tennis players and their coaches might provide the answer. There is a critical difference between the feedback a tennis coach provides, and the feedback on offer to professional investment managers.
Investment managers know, day by day, how they are performing, and how their performance compares to peers and to an index. This determines how much money they get to manage, and thus how much they are paid. But it tells them nothing about how to improve.
A tennis coach does not tell their client that they won their match 6-4, 6-4. They know that already. Their job is to split the performance of a tennis player into its component parts, and work out which have been effective and which not. For example, if drop shots are weak, it becomes a question of practising drop shots until they become almost instinctive, and so on.
Is it possible to do something similar for investors? Many interpret behavioural research to show that active investment management is a wasted effort. Rather than try to control our emotions, better leave it to computers that have no emotions to control.
But there is also an attempt to salvage active management by isolating what is skilful about a manager’s performance and providing coaching to make necessary improvements. That is what Boston-based Cabot Research attempts to do.
According to Michael Ervolini of Cabot, investment skill can be broken down into three sets of decisions: buying, selling and “sizing” — setting the size of each holding. Buying, regarded as a “strategy”, tends to be undertaken most rigorously while selling, regarded as a “discipline”, creates the biggest problem.
Selling, as this column has noted, is a neglected part of the investing process that often creates problems. Among retail investors, loss aversion, or an extreme unwillingness to take a loss on a holding, creates the biggest issues. People tend to hold on to their losers too long, in the hope that they will one day come good.
Among the 500 professional fund managers examined by Mr Ervolini, however, the problem is more with keeping “winners” too long. One in four professional portfolio managers, he finds, repeatedly make this mistake. This is in part due to the “endowment effect” — we value things that we hold ourselves more highly than the market does. There is also a problem of emotional attachment; people fall in love with their winners, and hold them to a lower standard.
The second greatest problem, afflicting one in six managers, is to do with sizing of holdings in winners. When a stock rises fast, these investors will suffer regret that they did not buy more when it was cheaper. While they are kicking themselves for not buying enough, they miss the opportunity to expand their holding while the price is still favourable.
How do you deal with these problems? The Cabot approach is to provide feedback, and lots of it. Once it identifies weaknesses in an investor’s game it can start providing the information to convince them that they have these weaknesses. Then they can attempt to remedy them.
For investors who hold their winners too long, warnings flash up on their screen prompting them to check their case for holding on to a stock, and pointing out that it has already done all that was expected of it. Subsequently, feedback can record what happened after the cue, and whether the investor would have been better or worse off for having followed it.
In this way, Mr Ervolini believes it is possible to improve a manager’s intuition. While instinct is innate, he holds that intuition is a cognitive process that happens to be automatic. It can be developed by practice in humans, just as a tennis player practising their drop shots can change their muscle memory.
This is not the only way to do it. For example, some hedge fund managers make a deliberate practice of closing all their positions at periodic intervals and deciding whether they want to re-buy all the stocks they were holding, at the prevailing price.
But the point is to diagnose our repetitive mistakes, and force ourselves to confront them. Mr Ervolini’s results with Cabot certainly look impressive; the fund managers it coached on average turned an underperformance of a percentage point into an outperformance of 1.5 percentage points over the course of five years.
Moves to apply behavioural research may create new anomalies as it eliminates old ones. But if active management using human judgement is going to survive the challenge posed by computers and quants, this kind of coaching will be needed.
— Financial Times
